Currency analysts in Danske Bank discuss the relationship between US data, Federal Reserve policy, and the US dollar.
The Fed’s determination to raise inflation and see further significant employment growth could support reflationary trading in the short term and undermine the dollar.
However, Danske does not see this policy as sustainable, and a sharp correction is due in the second half with a jump in the dollar and a fall in stocks as the Fed is forced to counter the threat of inflation.
Danske expects the euro / dollar (EUR / USD) exchange rate to fall sharply from highs of 1.21-1.22.
If this analysis is correct, the pound / dollar exchange rate (GBP / USD) is also likely to make strong sales above 1.4000.
The bank notes that Fed Chairman Powell has maintained a very soft position and insists on further significant growth in employment, as well as inflation.
With Powell openly calling for a further strong employment report, Danske does not expect any change in stance if this month’s employment data provides another strong growth in non-farm jobs.
“In practice, this means that it can take 3 to 6 months before the Fed starts talking about cuts.”
Thus, in the short term, reflationary trades can provide strong support. As long as this version remains in effect, the dollar may lose even more positions due to the growth of stocks and commodity currencies.
In this context, the dollar may weaken on Friday’s strong employment report.
However, if the US economy maintains high growth rates, Danske is confident that the Fed will have to respond to this by removing stimulus. By then, however, inflationary pressures are likely to increase further, increasing the risk of a sharp reaction with higher volatility and a sharp increase in bond yields.
Given the rise in the dollar in March, Danske expects that this development will lead to an appreciation of the US dollar, especially given the threat of a sharp decline in global equities.
This indicates; “The end game scenario is a bond sale when the dollar strengthens.”
At this stage, there is a threat of a sharp market correction, especially if traders hold a significant short dollar position.
“Once they let go, the markets would be caught short in the dollar while they had a good reflation position. Against the background of such expansion, the volumes will grow again. In our opinion, the volatility regime change and the dollar trend are a hidden shock expected to occur in the second half of the year. ”
Danske warns against reflationary trades due to the risk of market reversals. In particular, he warns of the risk of a quick and sharp adjustment that will exacerbate the pain in the forex market.
“It’s like collecting pennies in front of a skating rink.”