Geopolitical Risks, Fed Lift USD; Outlook Determined By US Fiscal Policy

The U.S. dollar staged a late rebound last week after coming close to breaking below its recent support level of 110 yen. Investor nerves ahead of the summit between the U.S. and Chinese presidents as well, as the risk-off generated by the U.S. airstrikes on Syria, had driven the dollar to a 1½-week low of 110.12 yen on Thursday.

Unexpectedly strong signals from the Fed that it will likely start the process of normalizing its balance before the end of the year also rattled the markets. The final blow came from the disappointing U.S. jobs report on Friday, which briefly pushed the dollar close to Thursday’s lows. However, hawkish remarks late on Friday by the New York Fed President William Dudley gave the greenback a last minute boost.

Fears that the Fed would raise rates more slowly than planned if it embarked on reducing its balance sheet of $4.5 trillion sent the yield on 10-Year U.S. treasury notes to a near 5-month low of 2.269% last week.

The Fed currently rolls over maturing bonds in order to maintain the size of its holdings unchanged, a process referred to as reinvestment policy. Any decision to shrink the balance sheet by letting the bonds run off when they mature could have a major impact on the bond market and would equate to a form of monetary tightening.

Dudley had fuelled expectations that the Fed would pause its rate increases once it starts the process of unwinding its bond holdings with remarks he had made on March 31. However on Friday, he attempted to clarify his earlier comments by saying that the Fed would pause its rate hikes for only a little while just to make sure that the move wouldn’t trigger any adverse reaction in the markets. This helped the dollar rebound sharply from the sell-off brought on by the surprisingly weak March jobs numbers.

Traders initially reacted badly to the big miss in the non-farm payrolls figure, which came in just below the key 100k mark for the first time in nearly a year. However, other parts of the report were more positive such as a big reduction in the number of part-time workers seeking full time jobs. Besides, slower jobs growth at a time of full employment can be a good thing as there would be less risk of the economy overheating.

Further contributing to the dollar’s rebound was the geopolitical risk aversion that partly eased, but which also led to increased demand for the dollar on safe-haven flows towards the end of the week, having initially hurt the dollar. There was relief in the markets that the U.S. President, Donald Trump, described his relationship with China’s President Xi as “outstanding” at the end of their two-day summit, easing concerns about a possible trade war. However, the renewed tension in the Middle East over Syria, as well as in the Korean peninsula, continued to weigh on market sentiment at the start of trading this week, particularly in Asia, where many Asian currencies, including the Korean won, extended their losses against the greenback today.

Against the yen though, the dollar is unlikely to make significantly gains while the geopolitical overhang persists as the yen itself is a safe-haven currency. Heightened risks of an all-out war between the U.S. and Russia over Syria, as well as military action in North Korea, could dampen market sentiment for some time yet, pending further developments. But even if the markets were to move past the current geopolitical jitters, the strong U.S. economic fundamentals may not be enough for the dollar bulls to resume the Trump rally. This would instead depend on whether the new Trump administration is successful in implementing its promised election pledges of big infrastructure spending and tax reforms.

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