The U.S. dollar has surged to its highest level since July 2020 compared to other currencies on rate hike expectations, a rally that analysts believe will continue to run with the Federal Reserve's push to tighten monetary policy.
The dollar climbed against nearly all its G-10 peers after Federal Reserve Chair Jerome Powell indicated Jan. 26 that more and faster rate hikes than the market previously expected would be coming in 2022.
"I think that the dollar strength is due to the fact that Powell gave no indications that the rate increases will be gradual," said Francesco Pesole, a foreign-exchange strategist with ING. "This is allowing markets to freely speculate on the pace and number of rate hikes."
On Jan. 27, a day after Powell said the Fed was "of a mind" to raise rates after their March meeting and declined to rule out a 50-basis-point hike then, the Dow Jones FXCM Dollar Index settled at its highest point in more than 18 months. The index measures the dollar's value against four currencies: the euro, the British pound, the Japanese yen and the Australian dollar.
The dollar is rallying on the possibility of the federal funds rate, which the Fed dropped to near zero in the early days of the coronavirus pandemic, being hiked by as much as 100 basis points by July, said Lee Hardman, a currency analyst with MUFG Bank. Market odds favor at least four rate hikes before the end of the year.
"The Fed's messaging … suggests that they could deliver back-to-back rate hikes in the early stages of the hiking cycle," Hardman said. "More front-loaded tightening should still keep upward pressure on the [U.S. dollar] in the near-term even if they don't deliver a larger [50 basis point] hike."
The dollar tends to strengthen when the Fed hikes rates as it boosts interest rates throughout the economy.
Market equilibrium
Rather than immediately hiking rates, or abruptly ending the Fed's bond-buying program, Powell indicated that future policy decision would hinge on the state of the economy, allowing the market to "find some sort of equilibrium," said Win Thin, global head of currency strategy at Brown Brothers Harriman.
"What was very noticeable in this meeting is that the Fed left all options open," Thin said.
Until equilibrium is reached, Thin said, the dollar rally will continue.
"Until the terminal fed funds rate moves higher, we are far from equilibrium and so, quite frankly, this dollar rally has a ways to go," Thin said.
Powell's hawkish tilt pushed shorter-duration Treasury bond yields higher and flattened the yield curve as expectations for more rate hikes accelerated.
This helped push the U.S. dollar higher against currencies linked to government bond yields that are expected to remain low, such as the euro, said Hardman with MUFG.
The U.S. dollar has gained ground against all its G-10 currency peers since the start of the year.
Stock weakness
Equities have stumbled as the Fed has signaled its move to tighten its ultra-loose monetary policies that have been in place since the start of the pandemic. The S&P 500, the Russell 2000 and the Nasdaq composite index have all dropped significantly. The S&P 500 is off more than 9%; the other two indexes are down about 15% since the start of the year. If weakness in U.S. stock markets continues, Hardman said, safe haven currencies like the U.S. dollar, Swiss franc and Japanese yen should perform well.
"It could eventually become more of a negative for the [U.S. dollar] if the Fed slows plans for tightening in response to equity weakness, but we are not at that point yet," Hardman said.