USD: Sell-off proves short-lived in anticipation of hawkish Fed policy update

The US dollar has quickly reversed the losses sustained at the start of this week and is back trading close to year-to-date highs ahead of tomorrow’s FOMC meeting. The US dollar initially sold-off yesterday in response to the correction lower for energy prices triggered by the pausing of tit-for-tat military strikes between the US and Iran. The price of Brent crude oil has fallen back below USD90/barrel encouraged by investor optimism that the US and Iran are engaged in diplomatic talks to end the Middle East conflict. President Trump told reporters yesterday that “there’s a good chance that something could happen, and if it does good. If it doesn’t, we go back to doing what we were doing”. On the other hand, Iran’s Foreign Ministry spokesperson Esmail Baghaei ted that while “it’s possible that mediators share messages from the US side about current developments”, no formal negotiations are currently taking place. Bloomberg has also reported that Oman and Iran are separately trying to reach an agreement to restart shipping through the Strait of Hormuz according to people familiar with the matter. Israeli Prime Minister Benjamin Ntanyahu is scheduled to meet President Trump later today.          

The de-escalation of military tensions in the region has helped at least temporarily to ease upward pressure for energy prices, and central bank rate hike expectations ahead of the latest policy meeting for the Fed, BoE and BoJ this week. The two-year US Treasury yield has dropped back by around 7bps from last week’s high, but market participants are still wary over the risk of a hawkish policy update from the Fed this week which is continuing to encourage a stronger US dollar in the near-term. The lack of clear forward guidance under Fed Chair Kevin Warsh has made it harder to assess the path for policy. We still expect the Fed to leave rates on hold this week which would give them more time to assess how inflation risks evolve over the summer. Recent soft inflation readings for June give the Fed should give them more leeway, but one can’t completely rule out the risk of a hike of Fed Chair Warsh wants to strengthen the Fed’s inflation fighting credibility amidst elevated energy prices and a persistent inflation overshoot. Even if the Fed leaves rate son hold as we expect then there are likely to be dissents from FOMC voters in favour of hikes. Dallas Fed President Lorie Logan has already stated that she favours modestly higher rates to “better balance the outlook and risks”. Market participants will also be closely scrutinizing comments from Fed Chair Warsh at the press conference although his reluctance to provide forward guidance is likely to mean that the outlook for policy later this year remains unclear. The stronger US dollar in the run up to tomorrow’s meeting indicates that market participants are expecting a hawkish policy update, and is currently poised to extend its advance below important resistance levels provided by year-date-highs.

AUD HAS BEEN THE BEST PEFORMING G10 CURRENCY THIS YEAR

Source: Bloomberg, Macrobond & MUFG Research

AUD: RBA Governor Bullock dampens speculation over faster rate hike

The worst performing G10 currency overnight has been the Australian dollar amidst more risk-off trading conditions. There has been another sell-off in AI-related chip stocks overnight in Asia. Bloomberg’s index of Asian semiconductor shares fell by -7.5%. The latest sell-off has been triggered by a report that a Chinese state-backed company has begun mass producing immersion deep ultra-violet lithography tools citing unidentified people familiar with the matter. According to the report the unnamed Shanghai-based firm is seeking to make about give DUV machines this year and targeting about 20 next year although progress on productions remain at an early stage. Bloomberg notes that investors are sensitive to any threat to ASML’s stranglehold on this part of the semiconductor supply chain, as well as signs of Chinese progress in producing chips in spite of US export controls. ASML has been banned from exporting its cutting-edge tools to China, namely the EUV lithography machines, as part of US-led export controls. AI-related and tech stocks have been correcting lower since last month created a more challenging backdrop for high beta currencies such as the Australin dollar which has benefitted from the AI build out (click here). It is one of the reasons why the Aussie has been the best performing G10 currency this year. At the same time, the Australian dollar has been undermined as well overnight by comments from RBA Governor Bullock who refrained from sending a strong signal that they are planning to hike rates again as soon as next month. She repeated that “the board is prepared to act as required to achieve its mandate, including by increasing the cash rate further if needed”. It leaves the Australian rate market comfortable with current expectations for one more hike later this year.