The US Dollar has appreciated strongly against the euro in November (+3%)
President Biden re-nominated Jerome Powell for a second four-year term as Chair of the Federal Reserve Board, nominating also Lael Brainard to serve as the Vice-Chair. Both are expected to win Senate confirmation. Having said that, the Fed’s expected monetary policy stance in 2022 will be mainly driven by the data (inflation, labor market).
Since the beginning of the year, the USD has appreciated by 8% against the EUR to $1.124, at the highest level since July 2020 (+3% in November).
We identify three factors behind the significant USD appreciation month-to-date. First, markets have brought forward the start of the Fed hiking cycle from H2:2022 to June next year. As a result, interest rate differentials have supported the USD.
The spread of 2Y1Y EUR versus USD interest rate swaps (a proxy for market pricing of central bank interest rates on a two year horizon), has widened by circa 50 basis points to -176 bps since July. Financial markets assign a small likelihood for the ECB to turn more hawkish.
Historically, the USD has strengthened before the first interest rate increase by the Fed. Considering the last four Fed hiking cycles, starting in 1994, 1999, 2004 and 2015, USD appreciated by circa 4%, on average, seven months before the first hike and 2% three months before.
Second, US economic data surprises (i.e. retails sales) turned positive for the first time in 4 months in November, while European data have been lukewarm, excluding the positive PMI outcome today. US real GDP growth is expected to be strong in Q4, according to the Atlanta FED GDPNowcast model (+8% qoq saar).
Third, Covid developments remain a downside risk for euro area growth and the EUR, as cases are rising across many economies and several countries have begun to tighten restrictions (Austria). These developments have weighed on EUR in the short term, although the impact on FX tends to fade when Covid-19 curves show signs of flattening.
Investors’ USD net positioning based on CFTC future contracts has increased, albeit it has not moved yet into (USD) overbought territory. Positioning could move higher in the coming weeks, favoring a long USD.
In the short-term, the Fed is likely to turn more hawkish on December 15th due to accelerating inflationary pressures, with market pricing following suit and interest rate differentials remaining in favor of the USD. Deteriorating economic activity, as Covid-19 cases continue to surge across Europe, remains a key headwind for the EUR.
Having said that, adverse pandemic developments, which could lead to a re-imposition of containment measures across the region, led equities lower in the past week. Specifically, the EuroStoxx index fell by 0.3% and further by 0.3% on Monday (+21% ytd). The Travel & Leisure sector underperformed declining by -4.7% wow (-1.1% on Monday).