The consumers in support of the dollar?
By Alexandre Hezez, Group Strategist
The dollar could appreciate in the short term as the prospects for rate cuts in the United States fade.
Markets are scaling back their exaggerated expectations in this regard, while the still fragile economy of the eurozone weighs on the single currency.
Chart: Dollar versus Euro
The Fed continues to try to reshape expectations. A member of the Fed’s Board of Governors, C. Waller, believed that the monetary policy conducted by the Fed seemed adequate in light of the disinflation movement and the slowdown in activity, particularly with the normalization of the labor market.
Tweet from Nick Timiroas (Chief economics correspondent, The Wall Street Journal)
If the Fed must ensure not to tighten its monetary policy excessively, it should not, according to him, rush either. The American inflation data, higher than expected last week, should lead to a reevaluation of expectations for interest rate cuts.
Chart: Anticipated Inflation / Overall Inflation / Core Inflation
Higher U.S. inflation could provide arguments for the hawks and strengthen both the strength of the dollar and the rise in yields of U.S. bonds. Indeed, persistent price pressures might prevent the Federal Reserve from cutting interest rates too early in the year, while the economy remains strong and officials worry about the consequences of premature easing.
Inflation tends to become entrenched. It has decreased significantly this year because some supply and demand imbalances have been resolved. Housing is a particular area of concern. Policymakers were counting on inflation affecting rents to start easing, but the latest CPI report showed that it still accounted for a significant portion in December.
It is still too early for Fed officials to start slowing down the pace of balance sheet reduction, but the discussion will soon become more relevant as market liquidity begins to have a significant impact.
Chart: Fed’s assets (in billions) versus Fed rate
The U.S. economy continues to show mixed signs, subtly indicating a gradual slowdown, conducive to a scenario of a soft landing. According to the Fed’s Beige Book, economic activity has changed very modestly since its last publication in November, while consumer spending remains relatively resilient and businesses report that inflationary pressures are becoming more moderate. The Federal Reserve’s minutes for December didn’t even mention rate cuts.
The latest releases show strong resilience, whether in terms of real estate or employment. The NAHB (National Association of Home Builders) confidence index for American home builders came in at 44 in January when it was anticipated at 39, after 37 in December, and building permits turned out much better than expected..
Chart: NAHB (developer confidence index) versus CaseShiller (house price index)
Retail sales came out significantly above expectations in December, at +0.6% for the month. Consumption was indeed driven by online sales.
These elements remind the Fed that the recent easing of financial conditions is likely to support activity and thus potentially a ‘second wave’ of inflation However, we are not in the same situation as in 2022.
We thought that expectations for interest rate cuts were too strong, but at the same time, we were drawing attention to the fact that the market would continue to believe in them for a few more months as economic figures deteriorated in the United States and disinflation accelerated at the beginning of the year. Our expectations are simply shifted in time.
Concurrently, the latest releases in Germany showed that the German economy contracted in 2023. We expect the euro to recover later in the year as the eurozone economy rebounds
Chart: German GDP (annual)
U.S. money markets are suggesting a 70 basis point cut in rates in the first half of 2024.
We expect a correction in expectations and, consequently, for the dollar to find some support over a 1 to 3-month horizon. A stronger dollar in the early months of 2024 seems more likely, leading to a drop in EUR/USD towards 1.05.
The euro is also likely to underperform in the coming months, largely due to the short-term weakness of the German economy (a consequence of the weakness of the Chinese economy).
Although we maintain a bullish forecast of EUR/USD towards 1.15 by the end of the year, downside risks will probably prevail in the short term. We are changing our outlook to neutral.
