The dollar came under renewed pressure on Tuesday as investors grappled with the impact of the Federal Reserve’s policy shift on inflation and choppiness in the US economic recovery.
The dollar’s slide pushed sterling to its highest level of 2020 and propelled the euro briefly above the $1.20 mark, which it last reached in May 2018.
Investors pointed to the US central bank’s recent announcement that it was willing to tolerate periods of higher inflation to make up for a persistent undershooting of its longstanding 2 per cent target, and that low unemployment itself will not drive policy action.
The new approach to inflation follows significant interventions from the Fed since the coronavirus-induced financial panic in March. In addition to slashing rates to zero and deploying a large bond-buying programme, the Fed agreed to support the markets for corporate debt, among others.
“It feels a bit like capitulation,” said Kit Juckes, head of forex strategy at Société Générale, about the dollar’s recent move. “The market has bought the Fed’s inflation view hook, line and sinker.”
Taken together with the unprecedented fiscal support ushered in by Congress and the uneven US economic recovery, the dollar was likely to depreciate further “in all but the most extreme” scenarios, said Gene Frieda, a global strategist at Pimco.
“The Fed’s aggressive monetary policy response has eroded the dollar’s yield advantage built up over a multiyear cycle of rate hikes . . . This advantage is unlikely to be restored anytime soon,” he added.
The dollar index, which measures the US currency against a basket of half a dozen peers, slipped 0.4 per cent on Tuesday, extending its losses to more than 10 per cent since its March high.
The pound rose as much as 0.7 per cent to $1.3457 while the euro was recently $1.1980.
The gains for the euro were resilient despite the bloc recording its first year-on-year fall in consumer prices since 2016.
Zach Pandl, an economist at Goldman Sachs, said that the European Central Bank appeared unlikely to push back on euro appreciation with rate cuts as it usually would, instead prioritising efforts to internationalise the currency after agreeing on an EU recovery fund.
Mr Pandl believed the EU’s plan to issue €750bn of bonds, in addition to other issuance tied to separate loan programmes, could help to boost the euro’s share of global foreign exchange reserves to 24 per cent from its current level of 20 per cent.
“In light of recent institutional upgrades, the euro may be an increasingly attractive alternative for global investors looking to diversify away from the US dollar,” he said.
While Mr Juckes called the expected bond issuance a “magic potion” for the euro and a “dream that its structural flaw is solvable”, he cautioned that the dollar’s dominance was unlikely to fade anytime soon. In fact, nearly 62 per cent of the roughly $11tn of global foreign exchange holdings are allocated to the dollar.
The dollar’s reversal in recent months comes after a multiyear period of strength versus its peers, which saw the dollar index climb roughly 9 per cent between the end of January 2018 and the start of this year.
US president Donald Trump railed against the strong dollar at the time, demanding via social media on numerous occasions for the Fed to lower interest rates. His sharp rhetoric also raised the spectre that US could intervene in currency markets for the first time in decades. In May, Mr Trump reversed course, stating that the strong dollar was a “great thing”.
Elsewhere on Tuesday, stocks in Europe trimmed early gains, with the continent-wide Euro Stoxx 600 falling 0.82 per cent. US stocks were 0.1 per cent higher in early trading, following the best August for global equities in decades.