rises and the likely central bank response have triggered increased volatility across the bond, equity and FX space. This has led to some pressure on popular summer carry trades and refocused attention on energy-exporting currencies backed by central banks ready to tighten. Expectations of Fed tightening will keep the dollar bid
USD: It’s All About the Fed
The continues to perform well as high energy prices raise expectations for a central bank response. President of the ECB, Christine Lagarde, made it pretty clear yesterday that the central bank would be hiking in September, and markets now price a further 75bp of tightening for both the ECB and the Bank of England. That seems excessive, but is hard to fight unless energy prices turn sharply lower soon.
Crucially – and after the June FOMC meeting – the market believes the will have to respond as well. Since that June FOMC meeting, two-year real USD swap rates have risen 30bp as investors buy into the only message we have heard from the Fed – the need to restore credibility when it comes to fighting inflation. While we do not think the Fed will hike next week, it remains very dangerous to fight this trend and, as we have been saying all week, we expect the dollar to outperform.
US data today is relatively light – just July S&P readings and . But with US President Donald Trump threatening a fresh military onslaught on Iran, expect investors to hold onto their long dollar balances into the weekend. is not far from June’s 101.80 high and an upside break-out cannot be ruled out.
EUR: Real Rate Spreads Moving Against EUR/USD
A hawkish hold from the ECB provided little support to the euro yesterday. The reasons for that appear to be high energy prices weighing on European growth prospects and, more importantly, a larger adjustment in real rates in the US than in the eurozone. Here, two-year real swap differentials have widened out to levels last seen in late 2024 when EUR/USD was trading under 1.10. We do not think EUR/USD needs to trade down to those levels now, but as long as energy prices continue to fire up Fed tightening expectations, we think the pair should be pressing the low 1.13s.
For today, the eurozone data focus will be the July flash PMIs and also the WAVE inflation survey. These should confirm the ECB’s risk assessment of downside risks to growth and upside risks to inflation.
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