The U.S. dollar climbed to its highest level against the Japanese yen in more than 2 decades.
The European Central Bank has a monetary policy announcement in less than 24 hours. Still, halfway through the week, persistent demand for U.S. dollars continues to be the primary driver of currency flows.
Even as U.S. stocks jockeyed around, USD/JPY marked its seventh out of eight straight days of gains. Typically Japanese yen crosses weaken in consolidative uneasy market environments, but the strength of USD/JPY took all of the Japanese yen crosses to multi-year highs on Wednesday.
The Federal Reserve’s aggressive tightening this year is the main reason for robust dollar demand, but the prospect of quantitative tightening (QT), which is the opposite of quantitative easing (QE), caused investors to shrug off mixed data and step up their purchases this month.
Last month the central bank laid out a plan to reduce its balance sheet starting on June 1st. The QT process involves capping the amount of reinvested principal payments, allowing more bonds to mature on their designated date.
However, the first tranche of debt does not mature until June 15th, which means the impact on the economy has yet to be seen.
One of the most critical consequences of QT is tightening of financial conditions and reducing liquidity in the Treasury market, which drives yields and the U.S. dollar higher.
Inflation data is also scheduled for release on Friday, and everyone is worried about heady price growth. Policymakers have been on the wires lamenting about high prices, and according to Treasury Secretary Janet Yellen, 8% inflation is just unacceptable.
We have every reason to believe that the CPI report on Friday will reinforce the need for aggressive and urgent action from the Fed.
Although stocks are holding steady, the equity and crypto markets are particularly vulnerable to the combination of QT and rate hikes. For forex, this means weakness for high beta currencies.
The European Central Bank has made it very clear that they plan to raise interest rates in July, so they will lay the groundwork and make a case for tightening when they meet on Thursday.
Part of the reason why they have chosen July instead of June to hike is that economic projections are prepared and released for this month’s meeting, which helps to make a case for tightening. Inflation, which is running at an uncomfortably high rate at a record-breaking rate of 8.1% in May, is the primary reason for the move, so there’s no doubt that inflation projections will be increased.
However, growth projections could subside as prices, supply chain, the Russian invasion, and rising interest rates curb economic activity. Yet between the ECB’s hawkish tone and the prospect of a brand new tightening cycle, we expect renewed demand for euros, particularly against the crosses.
While 1.08 EUR/USD is possible, traders will have to juggle demand for EUR and USD, which means overall gains could be limited.
Tonight’s Chinese trade report should not significantly impact Australian and New Zealand dollars. While the COVID lockdown will negatively impact exports, the appreciation of the dollar and euro boosts the value of China’s overseas holdings.
This week, the Australian dollar has seen very little demand after the Reserve Bank of Australia’s rate hike. AUD and NZD are likely to weaken the most if stocks sell off and the U.S. dollar continues to rise.
The Canadian dollar, on the other hand, is supported by rising oil prices, stronger IVEY PMI, and the prospect of healthy labor market numbers on Friday.