The US Dollar Index has fallen almost 6% since its March 2020 highs. This is no surprise given the sheer scale and speed of the Federal Reserve’s response to the pandemic – a $3 trillion rise in the balance sheet, a buying spree in US Treasury, agency, MBS and corporate debt, backstop programs in the corporate credit markets. In addition, Jerome Powell resorted to aggressive forward guidance (“we will not even think about shrinking the Fed’s balance sheet”), slashed the Fed Funds rate to 0.25 basis points and inked swaps lines with foreign central banks.
The message from the Federal Reserve’s marble palazzo on Constitutional was loud and clear to Planet Forex. The US central bank will do whatever it takes to avert a global deflation and the sort of credit Armageddon that crippled Wall Street after the failure of Lehman Brothers in September 2008.
The Euro, the world’ second most significant reserve currency and 57% of the US Dollar Index, was the obvious beneficiary of the Federal Reserve’s policy response to the pandemic. In essence, Powell killed the carry trade by eliminating the US dollar’s interest rate premium over German and Japanese money market rates. This meant a natural bid in the Euro, which rose from its 1.0650 lows in mid-March to 1.14 now, boosted by the sharp recovery in risk appetite on Wall Street, economic data worldwide and confidence about the Euro’s 750 billion Coronavirus Recovery Fund. While valuation is a lousy timing indicator in foreign exchange, economists peg the Euro’s purchasing power parity level at 1.25 and thus consider it undervalued at current levels. This means the ECB will not go ballistic if the Euro rises to 1.17 to 1.20 by year end 2020, which I believe is a credible target.