US dollar – Bullish trap or correction in sight?

While currency markets have calmed down somewhat, the Federal Reserve is still on an aggressive rate hike path that could see US rates top 3% next year. Moreover, geopolitical tensions remain high and the conflict between Russia and Ukraine could drag on.

From a technical standpoint, the US dollar looks overbought. Let’s take a look at the Dollar Index (DXY) and its year-to-date performance. The index is up nearly 8% since the start of the year. The RSI on the weekly chart signals overbought conditions, suggesting that the Dollar has already reached high highs.

That being said, recent economic data supports a more rapid tightening of monetary policy by the Fed, and there is no immediate sign that their hawkish stance might fade in the near term. With markets already anticipating a rate hike to 2.75%-3% through the end of the year, investors fear that the central bank will be forced to accelerate the tightening.

The greenback is also benefiting from strong demand for safe havens as markets remain in risk aversion mode. Geopolitical tensions have reached their highest level in a while. Unfortunately, the war in Ukraine may not end so soon and there are fears that it will spill over the borders. The impact of Russia’s invasion of Ukraine is already considerable, and an overall increase in geopolitical tensions could put the global economy at risk – even as it recovers from the scars of the pandemic.

What could stall the dollar rally? Once the markets see the Fed’s aggressiveness wear off, we could see a bigger correction in the US Dollar. Given that the market is already pricing in an aggressive bull run, it wouldn’t take much to trigger further dovish pricing.

A pick-up in risk appetite could lead to additional headwinds. Equity markets have managed to regain some ground recently, although there may be further turbulence ahead. All eyes are on the tech sector where the darlings of a time got crushed.

Against which currencies could the US dollar have a better chance of outperforming?

The euro has been in a strong downtrend since June 2021. The common currency’s weakness was initially fueled by a dovish and passive ECB. A spike in inflation, the war in Ukraine and bleak growth prospects created additional pressure. The European Commission recently lowered its economic growth forecast for the eurozone by 1.3 points to just 2.7%.

At the same time, inflation should remain closer to 7%. While the ECB has become somewhat hawkish – it could raise rates as early as July this year – it could end up being too little, too late. So it could only be a matter of time before EUR/USD hits parity – the next major downside target.

The short-term outlook for the pound remains mixed at best. The dovish revaluation after the last Bank of England meeting triggered a sell-off. Pound traders shifted their focus from inflation to the central bank’s dramatic warnings of a significant economic downturn. GBP/USD recovered quite slowly. Although a break above 1.25 could trigger a short pressure, there is a high risk that a bullish trap is around the corner.

How will commodity currencies behave?

The Australian dollar suffered from a broad risk aversion chart and the COVID crisis in China, which raised concerns of a slowdown in economic power. An improvement in risk appetite could give the Australian dollar a boost, but weak economic data out of China could continue to cause noticeable headwinds in the near term.

The Canadian dollar may find it easier in the short term. Soaring oil prices have supported the currency, and it is possible that the Bank of Canada will raise rates more aggressively in the coming months.

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