The US dollar seems set to stay in ascendancy in the short-term

The performance of currencies since the Russia-Ukraine conflict on February 24th can be split down trade lines. In short, countries that have seen positive terms of trade responses, given a hefty share of commodity exports, are the ones that have seen currency strength. In contrast, hefty commodity importers, particularly of energy, have seen their terms of trade deteriorate and their currencies have suffered as a result.

The dollar is better placed given its hefty oil output, while other strong energy and commodity exporters, such as Australia, have also seen their currencies rally. The question is whether this breakdown is likely to persist, especially as commodity price volatility settles down. There is a fair chance that these terms of trade effects will become less prevalent in time. Replacing them could be monetary policy as more central banks gear up to hike rates (such as the ECB), while those that have started could increase the pace (the Fed).

The impact of Fed policy on the dollar has received significant airtime, but its effects are overplayed. For a start, recent tightening cycles seem to show that the dollar rallies as the Fed builds the case for higher rates, but then starts to fall back as these rate hikes are delivered. Can we expect the same again?

A distinction this time is that tighter policy is taking place against a substantial surge in inflation that has gone way beyond the 2% target. This not only creates the possibility of a more rapid and volatile rate-tightening cycle, but it also says something about the financial market effects that tightening needs to have if it is to pull inflation back to target.

What we mean here is that it is not sufficient for the Fed to lift rates; the bank will also need to see a material tightening of financial conditions, for it is these that exert the demandsapping momentum that’s required to bring excessive demand down to supply levels that are much more constrained by things like labour shortages and global supply chain tensions. These financial conditions include moves such as higher bond yields, wider credit spreads, lower equity prices, and more.

In other words, Fed tightening has to be sufficient to create a risk-off environment,and it is this that usually leads to a firmer dollar. In the past, when inflation was far more benign, it was not so clear that the Fed needed to tighten financial conditions so much. But it is now, and that creates the prospect of strong and persistent dollar strength. It could also offer salvation for the yen, which has weakened sharply since the invasion of Ukraine thanks to the deterioration in Japan’s terms of trade, as we mentioned earlier. Should risk aversion rise as the Fed tightens, it may help the yen recover as yen-funded carry trades in currencies such as the Aussie are unwound.

For the euro, the most immediate consideration is the second round of the French presidential election on April 24th. The first round, held on Sunday, saw incumbent Macron take the most votes, with just over 27%. Far-right candidate Le Pen took around 24% and goes into a run-off against Macron in just under two weeks. Polls currently indicate that Macron will win this head-to-head battle by a razor-thin margin, much closer than his 66%-34% victory over Le Pen in 2017.Should polls remain this close or narrow further, then euro investors may grow nervous, as there is little doubt that a shock Le Pen win would unseat the currency and the French bond market.

Mr. Steve Barrow, Head of Standard Bank G10 Strategy, remains fairly confident that Macron will win on April 24th, but it needs repeating that the risks here are asymmetric; the euro is unlikely to rise significantly if Macron wins, but it will fall sharply if he loses. So, even though he expects Macron to prevail, he still sees the euro staying subdued and testing the lower end of the 1.05-1.10 trading range that he has been talking about for some time now.