Tensions mount in foreign exchange markets as US dollar surges

THE US dollar is moving sharply higher on foreign exchange markets. Changing monetary policy expectations and geopolitical tumult are ripping up expectations from earlier this year of the dollar easing amid a softening US economy and accommodation from the Federal Reserve.

The latest sticky US inflation data, coupled with continued robust activity and turmoil in the Middle East, has sparked surging dollar demand. The market has gone from pricing six Fed rate cuts this year to well under the three projected in the latest Fed dot plot.

If inflation is coming down in a bumpy manner and real activity is holding up, why should the Fed cut this summer? Using Stephen Jen’s dollar smile picture, in which the US dollar tends to be strong when it economy either lags or outperforms, it’s as if both sides of the smile – a risk-on economy and risk-off geopolitics – are underpinning the past week’s breakout.