USD: some consolidation is in order

The dollar is now about 2% off its highs seen at the end of last week. The move was likely driven by some position liquidation and a preference for currencies such as the Japanese Yen (JPY) and Swiss Franc (CHF) amid turmoil in global equity markets. In fact, yesterday’s FX activity looked like the big sell-off in EUR/CHF following comments from the Swiss National Bank (SNB) that triggered downside stops in USD/CHF and caused a slightly wider dollar adjustment.

The stability of the Chinese renminbi (CNY) this week also contributed to this period of consolidation. The overnight 15bp cut in the 5-year prime rate – aimed at supporting the real estate sector – instilled some more confidence in Chinese asset markets. However, we cannot see USD/CNY returning directly to 6.50. Instead, a trading range of 6.65-6.80 may develop following the recent CNY devaluation.

However, the emerging market environment still looks challenging as the stronger dollar effectively exports tighter Fed policy around the world. Yesterday we saw rate hikes in Egypt, South Africa and the Philippines. After devaluing the Egyptian pound by 15% in March, the authorities there are very much struggling with the external environment. This saw Egypt’s 5-year sovereign credit default swap hit all-time highs of 940 basis points and is a reminder of the challenge facing North Africa due to soaring food prices.

For today, the data schedule is relatively quiet and there could be some interest in what the G7 finance ministers and central bank governors have to say after their meeting in Bonn. Reports suggest that Japan would like some tweaks to the final G7 communiqué, but we highly doubt there will be a change in the basic language of FX, that exchange rates will be market determined, and that excessive volatility and disorderly movements are avoided.

DXY might correct a bit lower to 102.30, but we see this as bull market consolidation, rather than peak construction activity. It’s only when the Fed pours cold water on tightening expectations that the dollar should top. And yesterday, Fed hawk Esther George said that even this “tough week” in stock markets would not derail the Fed.