Two-year Treasury Yield Reflects Strength of U.S. Dollar. However, Things Can Change within a Year.

Now is not the time to fight Fed hawks or dollar bulls as the euro/dollar pair is back in the spotlight, but the rationale for a more promising outlook for the pair in 2022 remains unchanged as Fed and ECB policy expectations are being adjusted. Strong directional trades should also be ignored for now, as well as the return of risk appetite to help the dollar bears. As of Jan. 31, Bloomberg's interest rate probability gauge showed about five Fed rate hikes this year (some analysts expect as many as seven), while eurozone benchmark rates are expected to remain relatively flat through 2022.

It is the Two-year Treasury yield that currently portrays the dollar the most accurately. The next leg of the Fed-led dollar rally has begun, and while some consolidation may follow last week's big moves, the market is still poised to bet on more interest rate hikes, not fewer, with the dollar being supported by the bearish stance dominating over the performance of risky assets. This may last until the March FOMC meeting (the meeting concerning Fed’s monetary policy). However, more and more traders express their opinion that during 2022 markets will return to a less hawkish tone in regards to the Fed’s policy against the more decisive rhetoric and/or even actions from other major central banks (especially the European Central Bank), which will seriously challenge the dollar bulls.

Meanwhile, since the beginning of January, the U.S. Two-year bond yield rose nearly 63% (to almost 1.22% on Jan. 28 from 0.75%), while the U.S. dollar spot index is up nearly 9%. Also, since the start of the year till January 27, the Nasdaq is down about 14.7% and the Dow Jones Industrial Average is down 6%.

The recent Fed's hawkish press conference and persistently high inflation have bolstered yield-driven gains in the greenback lately, but any attempts to take profit will appear premature at this point. However, looking ahead, the main risk is that too bullish expectations are only reflecting the base case “maximum tightness” scenario, which has more odds to be aligned downward down the road, than the opposite way. This reasoning becomes even more convincing if, as we expect, the European Central Bank adopts a more hawkish tone, implying that the expected relative rate differential could become more favorable for the euro/dollar pair.

With all the inflation fear being factored in, we still believe that developments in the real economy could dim the euphoria around Fed rate expectations and limit further dollar gains. In this respect, Q4 YoY U.S. GDP growth of 6.9% may have been impressive, but it still reflects the highly volatile base, while the breakdown of the data reflects the underlying weakness, as inventory builds (up 4.9 percentage points) were the main contributors while ending sales to domestic buyers (GDP excluding inventories and trade) showed a more modest increase of 1.9%. Some of the Q1 forecasts (such as housing data or PMI) point to weaker growth momentum as the Omicron spreads. This softer upside is well reflected by the recent Bloomberg US Economic Surprises Index of 0.1372, up from 0.3804 at the start of the year.

And yet we are not among those who see nothing but bad news during 2022. As the global economy continues to adapt to the pandemic (we are not hailing another reopening phase here), the Fed is doing just enough to contain rising inflation expectations, and the CPI acceleration will hopefully start to slow, prompting markets to refocus on the still-predominantly-favorable earnings reports (with the corresponding risk being adjusted across asset classes), again making dollar bulls more vulnerable. Expect this idea to gain popularity throughout the year.

Current Fx market extremities can exacerbate price action when sentiment changes. Positioning was overwhelmingly favorable to the dollar at the start of 2021 (when the market was underweight), but it became more profoundly bearish later on. CFTC data confirms the exponential growth of long dollar positions throughout 2021 and early 2022, accounting for about 75% of CFTC contracts as of January 18. Although below 85% compared to 2017, 2015 and 2012, this is still indicative of a dramatic shift in positioning from early 2021 and gives bears more opportunity when the sentiment changes.