Thanks to a strong January employment report, the greenback $USD Index(USDindex.FOREX)$ made an impressive comeback from the weakness since Q4 2022. Someone might expect the strength could persist and even test 2022’s high, but I regard this as a rebound and the dollar will likely trade in a range between 100 to 108 (Dollar Index basis) in 1H 2023.
EUR vs 2-year yield differential between US and Germany
First of all, the strength of greenback last year mainly came from an aggressive rate hike by Federal Reserve that kept the bond yield evaluated and widened the yield differential. As the chart shown, the yield differential of 2-year bond between US and Germany kept widening since 2H 2021 and reached the peak at Q3 2022.
In the meantime, the dollar was on the uptrend against euro and other major currencies. When there was expectation the Fed will slow the hike pace, and ECB was becoming more hawkish to tackle inflation, the yield differential narrowed since Q4 that caused the weakness of dollar.
After the FOMC meeting and before the employment report, the market downplayed the need for Federal Reserve to hike rate and even expected a rate cut by the end of this year in response to possible recession, turned a deaf ear to what J. Powell was delivering. Disinflation he mentioned is a term describing the inflation is dropping, which is nothing new that we can see from the inflation data (Benchmark, Core or PCE) in the last few months, and didn’t mean the inflation have dropped to the target level. His remark on 7 Feb about rate could be hiked to a level higher than market expectation showed there are more works Federal Reserve need to do.
The strong employment report reminded investor inflation is still a major risk to the economy and the Federal Reserve might need to hike further to contain inflation. Market’s expectation on the “terminal rate” revised upward and the bond yield moved higher that contributed to the rebound of the greenback in the last few days.
There are many factors affecting the movement in FX market, but the yield differential seems having a dominant effect in the last few quarters and could be the factors to watch in 1H 2023. I keep my conviction the Fed Funds rate will peak at 5.00% (lower band), which mean two more 25bp hike is coming. However, the hiking pace of ECB is even more hawkish and a 50bp rise is expected in their next meeting, and more could follow after. The higher and stubborn inflation in eurozone could make ECB keep hiking rate even if Fed paused, that might translate to narrower yield differential that is not positive to the greenback.
Another interesting area to note is the yield of US 2-year note. The inversion of yield curve is implying a recession, but what if US can avoid recession, especially when the US job market is surprisingly impressive?
Assuming US will not have recession, the yield spread between 2-year and 10-year bond should narrow, then how will they move respectively? A normal yield curve is 10-year yield higher than 2-year yield, while I don’t think 10-year yield will have the potential to rise to 4.5% or higher due to disinflation and technical reason, there is not much room for 2-year yield to rise further and even has a potential to retreat. A lower 2-year yield will lower the yield differential against other major currencies, that is negative to the USD. Even US 2-year yield revisit last Nov’s high, the Germany 2-year yield have risen 50bp from that level already.
2-year bond yield, US vs Germany
Since the rebound of the greenback released some overbought pressure and created a better entry point, you might consider a long position on EUR $Euro FX - Jun 2023(EUR2306)$ now, a short-term (1 Month) target at 1.1000 and a longer-term (1st Half) target at 1.1500. Stop loss could be set at 1.0500.
If you disagree with me and believe the greenback in a reversal mode, you might consider a short position in gold $Gold - Jun 2023(GC2306)$ since it could face further pressure after recent correction since it still accumulated meaningful gain in the last few months.
Disclaimers
Above information are for illustration only and there is no guarantee on the accuracy of the information. They should not be treated as investment recommendations or advices.
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