The dollar pulled back late last week as traders reassessed Fed rate-hike prospects, with the Fed not outpacing the ECB's own tightening cycle. A revived carry trade funded in yen is giving EUR/USD room to firm, even as JPMorgan and Oxford Economics both flag reasons the dollar could still catch up.
The US dollar hit a new local high on Friday but retreated toward the end of the week as the market reassessed the prospects for a Fed rate rise. Other central banks, including the ECB, have already begun or are set to begin their own cycles of monetary tightening, which is holding back the greenback's advance.
Catch-up trading could still favor the dollar
According to JPMorgan, the US dollar was undervalued by approximately 2-4% before the FOMC meeting, based on factors including the interest rate differential. At the same time, the start of the Fed's rate-hiking cycle gives the green light to so-called catch-up trading. Speculators, who have been reducing their long dollar positions over the past seven weeks, may now switch to the opposite strategy, creating conditions for the USD index rally to continue.
The dollar also draws support from the narrowing yield spread between 30-year and 2-year Treasury bonds, which indirectly signals market confidence that the Fed will fight inflation by raising rates. Historically, a narrowing spread has supported the DXY, though this time it stems more from buying of longer-term bonds as short-term yields rise with rate hikes.
Oxford Economics projects that over the next five years, US interest rates will rise faster than in Europe due to greater adoption of artificial intelligence technologies, lifting productivity, tax revenue and GDP growth. That return of the American exceptionalism theme could support the greenback, with US business activity outpacing Europe and Asia.
Yen's return as a funding currency lifts EUR/USD
The market had expected too much from the Bank of Japan's hawkish shift ahead of the September Policy Board meeting. The rise in the overnight rate, followed by signals from Kazuo Ueda that the cycle would continue, failed to strengthen the yen. Instead, two dissenting votes on the rate decision fed a rally in USD/JPY.
That has pushed the yen back into use as a funding currency for carry trades, and it is helping EUR/USD find its footing. The intervention risk that had threatened to break the upward trend in USD/JPY previously forced traders to steer clear of the yen, using the euro to fund their trades instead.
Source: ActionForex
Trading involves risk.
Risk Disclaimer
