Assessing the Factors Behind Dollar Strength and Future Projections for EUR:USD Real Rates

Still awaiting the turn in US activity data

The underlying factors driving FX markets became "crystallised" over the summer, as investors waited in vain for a negative turn in US economic activity that would justify a dovish shift in both the Federal Reserve's rhetoric and market pricing. However, since forward-looking indicators and evidence from the job market have not shown enough reason to cast doubt on the resilience of the US economy, US yields have faced limited resistance once again. This has made it increasingly discouraging, particularly in real terms, to play the long bearish game through dollar shorts.

At present, the US dollar index finds itself at a critical juncture, trading close to 104 (a multi-month high), and is about to face a month where decisions made by the central banks of both the US and the eurozone will determine whether it can break through to the March peaks (105.60) and beyond. Our economists expect no further interest rate hikes by the Federal Reserve, and while it is a close call, we anticipate the European Central Bank to deliver one final 25bp raise in September. In other words, we have reason to believe that the dollar may have reached its peak around current levels.

Another reason for the dollar's resilience has been the influx of negative news from China. The dollar typically benefits from a deterioration in Chinese sentiment through two channels: directly through yuan depreciation (to which USD is highly correlated) and indirectly through the risk environment channel. It is conceivable that there could be a further deterioration in investor sentiment regarding China in the coming months. However, the People's Bank of China's determined defence of the renminbi means that the dollar may only gain indirectly from these developments.

Looking beyond the near term, monetary policy divergence is expected to remain the overwhelmingly predominant factor driving currency trends into the next year. Another way to consider this is through short-term real rates. For example, EUR/USD has closely followed its short-term real rate spread since 2020. If nominal rate fluctuations have been the primary force behind these real rate changes thus far, the end of tightening cycles may result in a period where the inflation rates, on the right side of the subtraction, gain more significance.

 

Our EUR:USD real rate forecast

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