Fed’s aggressive stance supports dollar exchange rate

Nordea expects monetary policy developments to dominate the dynamics of the dollar and euro exchange rates, at least during this year. The bank notes:

“The tug-of-war between the Fed and the ECB will be crucial for EUR/USD this year. The key questions will be which central bank will be the most hawkish and which one will deliver on its commitments.”

Nordea expects inflationary pressures in the US to maintain pressure for more aggressive monetary tightening from the Fed, with the central bank likely to authorize a series of rate hikes.

“A tight labor market with strong wage pressures supports expectations for aggressive rate hikes, and inflation indicators are expected to show that we have not yet seen a peak in U.S. inflation.”

The bank summarizes, “The Fed will raise rates four times this year by 25 bps starting in March, followed by four more hikes in 2023.

A decision on balance sheet reduction will be made in the summer.” This will push US short-term rates to at least 2% by the end of next year.

Nordea expects the rate hike to boost the dollar:

“We still expect a renewed strengthening of the dollar in the second and third quarter of this year.”

However, Nordea expects the dollar to weaken against all major currencies in 2023, e.g. the dollar/yen (USD/JPY) exchange rate to fall to 110.0 by the end of 2023.

The ECB is still playing catch-up….

Following last week’s ECB meeting, Nordea expects the central bank to take a more hawkish stance than previously expected, although it does not expect the first rate hike to be authorized before December.

According to Nordea, “The ECB will decide in March to stop net bond purchases around the end of August. Rate hikes of 25 bps will follow in December 2022, March 2023 and September 2023.”

Given the general trends in interest rates, Nordea still expects the US dollar to strengthen against the euro this year.

Nordea expects the euro to remain vulnerable: “We are therefore not prepared to call a decisive upward movement of the euro from here.”

However, the bank has adjusted its forecasts given the ECB’s more hawkish than expected stance, which reduces the scope for euro losses.

“We have raised our year-end forecast for EUR/USD, expecting a revaluation of the euro by the end of the year and a more sustained euro dominance next year.”

Nordea now expects the euro to dollar (EUR/USD) exchange rate to be 1.10 by the end of 2022, up from 1.08 previously, with an increase to 1.18 in December 2023.

Bank of England rate hike will support sterling

Nordea believes developments in the UK will be similar to the US with persistent inflationary pressures.

It notes: “Inflation figures will continue to rise in the coming months, forcing the Bank of England to continue tightening monetary policy.”

The Bank adds: “Rate rises will be followed by a reduction in the Bank of England’s balance sheet. The UK will thus face a significant tightening of financial conditions.”

Nordea expects this to be a decisive element that will support the British currency: “we expect sterling to resume strengthening in the coming months”.

The Pound Sterling to Dollar (GBP/USD) exchange rate is forecast at 1.42 by the end of 2023, mainly due to the weakening of the US currency.