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Soft, hard or not to land? The dance of the dollar in the heat of the US economy

Date: April 2, 2023 Time: 00:18:54

‘Cash is king’.. Or the mantra that cash is king when markets go wrong. This was one of the great terms associated with the markets throughout 2022 with the dollar leading the way. The greenback corresponds to the perfect refuge for those investors who were looking to avoid the ups and downs of the stock market, represented to the fullest with the bear market on Wall Street that was experienced last year with a drop of more than 20% from the all-time highs.

But what was valid a few months ago may not be replicable today. The fate of the US currency has a strong connection to the monetary policies of the Federal Reserve. A monetary institution that is now seeking to find the terminal rate of the most appropriate interest rates to make the disinflation process continue to progress properly.

The dilemma between the members of the Fed is getting bigger and bigger. Fundamentally, because they want to avoid the chronification of inflation, but, at the same time, avoid an economic crisis. The last to speak was the president of the Minneapolis Fed, Neel Kashkari, who stressed that the FOMC wants to “avoid recession”, but that they know that “they must reduce inflation”. Fitting the pieces of the puzzle is not easy.

In these, the dollar, whose path goes hand in hand with the soft, hard or no landing of the US economy, has made a hard 180 degree turn to start the year, as a result of the wave of upward macroeconomic data, which have injected uncertainty about the path of inflation and growth, as well as how the Fed will respond.

Inflation and growth dynamics point to increased political uncertainty as the global monetary tightening cycle matures. As the data has evolved, so has the debate over which landing scenario will finally materialize later this year. Each of them presents considerably different economic conditions, with different indications for the North American currency.

“Although the market consensus points to a depreciation of the dollar later this year and next, the current economic context suggests more upside potential risks to our forecasts until the second half of 2023, since two of these three would be constructive developments for the dollar”, says Bank of America’s currency analysis team in a recent report.

The reasons for the fall of the dollar from the cyclical highs reached in autumn 2022 are justifiable, in the opinion of the entity. “The overcoming of the inflation peak in the United States in the midst of the reopening of China and the improvement of the economic and energy prospects in Europe have served to considerably reduce the risk premium that supported the dollar in 2022”, he highlights.

World energy prices have fallen and supply chains have thawed. And the volatility of the financial markets in currencies, rates and equities has been reduced. As far as currency markets are concerned, as we move into 2023, it is likely, as these experts are described, that these factors “will have less impact on price developments, especially as new risks arise.

One of the most influential factors for the dollar has been the evolution of inflation and the simultaneous evaluation and impact of Federal Reserve policy. Federal towards a smaller magnitude of the increases, passing through the turn towards a possibly lower terminal rate, until another change of direction towards the rate cuts planned for the second half of 2023

The different scenarios

The recent dollar low coincided with Jerome Powell’s February press conference, in which markets latched onto Chairman Powell’s lack of opposition to market pricing, his clear acknowledgment of deflationary forces. Since then, however, the surprises of first-tier Americans have served to remind the market that beating the inflation peak is not the same as advancing in a straight line towards the 2% target. Both prices and the dollar have been adjusted upwards accordingly.

In the event of a soft landing for Bank of America analysts, it would probably be “the most constructive for risky assets and the least constructive for the dollar.” In this case, the inflation situation would be resolved more or less gradually, along with the monetary tightening already underway in the system, and a generalized recession would be avoided.

In a hard landing, the final trajectory of inflation would be more ambiguous. “In this case, inflation and aggregate demand would reverse simultaneously, as job creation would begin to trend negatively and growth data would reflect further contraction,” Bank of America analyzes. “In this environment, deeper rate cuts would occur, which would only partially weigh on the dollar to the extent that they are not offset by similar cuts abroad and by broad risk aversion,” he adds.

Finally, one scenario that has been receiving a lot of attention lately, mainly due to recent signs of resilience in the US economy, is the “no landing” scenario. In this case, inflation would remain elevated or decline only modestly, while activity and employment data would remain elevated, even amid more aggressive Federal Reserve policy.

“As for the dollar, its recent (albeit nascent) appreciation could be viewed through the ‘no landing’ prism, with equities and credit losing momentum, but not slumping, as the terminal rate rises and declines. the inversion of the curve in the short term… A ‘non-landing’ would support the dollar”, conclude these experts.

Puck Henry
Puck Henry
Puck Henry is an editor for ePrimefeed covering all types of news.

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