USD weakening trend regains momentum after Middle East risk fades

USD: Fed policy back in focus as USD falls to fresh year to date lows

The US dollar has fallen to fresh year to date lows overnight as the this year’s downward trend has resumed following the easing of geopolitical tensions in the Middle East. Broad-based US dollar weakness helped to lift EUR/USD and cable above 1.1700 and 1.3700 overnight as they continue to move back closer towards the highs set back in late 2020/early 2021 when they peaked at just above 1.2000 and 1.4000. Renewed US dollar weakness has also coincided with decline in US yields. The 2-year US Treasury yield has now fallen for five consecutive days alongside the US dollar sell-off. The easing of geopolitical tensions in the Middle East and sharp drop in the price of Brent crude oil (-17%) has dampened investor concerns over upside risks to the inflation outlook and refocused market attention on the potential for the Fed to cut rates further this year if inflation does not pick-up as much as expected in the coming months in response to tariff hikes. The US rate market has moved to price in more Fed easing over the last couple of days encouraged as well by comments from Fed Cahir Powell at the semi-annual testimony before Congress. Chair Powell indicated that future trade deals may allow the Fed to consider cutting rates.

National Economic Council Director Kevin Hassett has predicted a sequence of trade deals around 4^th July which is also the Republican’s aspirational deadline for passing the tax bill. The 90-day delay for implementing the higher “reciprocal tariff” rates will then end shortly afterwards on 9^th July. Trade deals to avoid implementing the higher “reciprocal tariff” rates and/or extension of the deadline for say another 90-days would be the most supportive outcome for financial markets and the global economy. It could encourage the Fed to resume rate cuts sooner although a rate cut as soon as next month on 30^th July is still judged as unlikely. There still only around 6bps of cuts priced in by the US rate market. The release of the nonfarm payrolls report for June at the start of next month would have to be weak to encourage market expectations for the Fed to cut rates sooner.

At the same time, it has been reported again that President Trump is considering naming a replacement for Fed Chair Powell well ahead of his term ending in May of next year. The WSJ has reported that President Trump is toying with the idea of selecting a replacement by “September or October”. According to the report, President Trump’s ire towards Chair Powell could prompt an even earlier announcement sometime in the summer. It highlights how an early pick could be used as way to try to undermine the Fed’s policymaking under Chair Powell providing a further potential trigger for a loss of investor confidence in the US dollar. President Trump is reportedly considering former Fed governor Kevin Warsh and National Economic Council director Kevin Hassett to be the next Fed Chair. Treasury Secretary Scott Bessent is being pitched to Trump by allies of both men as a potential candidate as well. Other contenders include former World Bank President David Malpass and Fed governor Christopher Waller. We outlined some thoughts on the candidates in our latest FX Focus report (click here). A candidate who is perceived as being more open to lowering rates in line with President Trump’s demands would reinforce the US dollar’s current weakening trend.

In other news overnight, the Fed board voted 5-2 to propose changes to the enhanced supplementary leverage ratio. The revisions would reduce holding companies’ capital requirement under the ratio to a range of 3.5% to 4.5% from the current 5%. Their banking subsidiaries would see that requirement lowered to the same range from 6%. Michelle Bowman the vice chair for supervision at the Fed stated that the “the proposal will help to build resilience in the US Treasury markets, reducing the likelihood of market dysfunction and the need for the Fed to intervene in a future stress event” A view backed by Chair Powell who noted that “when the leverage ratio is binding, it discourages banks from undertaking low-margin, fairly safe activities, such as mediation in Treasury markets”. The Fed’s staff said the proposal would reduce the aggregate capital requirements of the eight biggest banks by USD13billion.         

USD IS ATTEMPTING TO BREAK LOWER OUT OF MULTI-YEAR RANGE

Source: Bloomberg, Macrobond & MUFG GMR

EUR: German fiscal policy shift continues to encourage stronger euro

The move lower in US yields has not been matched in the euro-zone where yields have held up resulting in spreads moving in favour of a stronger euro against the US dollar. A number of factors have helped euro-zone yields to hold up this week including some stronger economic data releases and the German government’s plans for looser fiscal policy. The release of the German IFO survey for June revealed that outlook for growth in Germany continues to improve. The more forward looking expectations sub-component rose to its highest level since April 2023. IFO President Clemens Fuest stated that the “German economy is slowly building confidence”. The improvement in business confidence has been supported by the government plans for looser fiscal policy which are helping to provide an offset to concerns over disruption to trade from President Trump’s tariffs. There is still the lingering risk that a higher reciprocal tariff rate of 20% or even 50% could be implemented from 9^th July.

Earlier this week Chancellor Merz’s cabinet approved the government’s 2025 budget and medium-term finance plan. This year’s budget includes new debt of EUR82 billion that will rise progressively to just over EUR126 billion in 2029. Over the five years through to 2029, net new borrowing will total about EUR500 billion. It will help to boost defence spending from around 2% of GDP up to 3.5%. The government’s other key priority will be increasing public investment and under the plans annual spending will exceed EUR100 billion totalling around 2.5% of GDP on average. The significant shift to looser fiscal policy in Germany will help to provide more support for growth in Germany in the coming years which alongside additional debt issuance will support relatively  higher government bond yields. It is another important reason why the euro has already  strengthened so much against the US dollar this year.             

KEY RELEASES AND EVENTS

Source: Bloomberg & Investing.com