Dollar Weak Despite Risk Off Impulses

May 21, 2025

Win Thin

Markets moved into risk off mode on rising Middle East tensions; Fed officials continue to set up an extended pause; Canada April CPI data ran hot
UK April CPI ran hot; Iceland cut rates 25 bp to 7.5%, as expected
Reports suggest market participants see no clear consensus on BOJ tapering; Indonesia cut rates 25 bp to 5.5%, as expected

The dollar remains under pressure despite risk off impulses. DXY is trading lower for the third straight day near 99.449 despite reports of Israeli plans to attack Iran (see below). Clean break below 99.470 sets up a test of the April 21 cycle low near 97.921. Higher UST yields are not helping the greenback (see below), supporting our view that the loss of confidence in the US is a major driver of global markets. in the absence of any key data, the dollar remains vulnerable to more downside this week. USD/JPY traded as low as 143.45 as JGB yields continue to rise (see below). Elsewhere, the euro is trading higher near $1.1345 and sterling is trading higher near $1.3415 after April UK CPI ran hot (see below). We continue to view any dollar relief rallies with skepticism. Easing trade tensions have removed a significant headwind on the dollar over the short-term, but those tensions are likely to pick up over the next couple of weeks as new (and higher) tariffs are announced. Even a resolutely hawkish Fed has done little to help the greenback as stagflation fears intensify.

AMERICAS

Markets moved into risk off mode overnight on reports that Israel is planning an airstrike on Iran’s nuclear facilities. Given that the US is trying to complete a nuclear deal with Iran, we doubt the US would sanction such a provocative act now. There have been many reports about how the US has sidelined Israel in Middle East diplomacy and so this could be Israel trying to re-assert its role in regional matters. Either way, the report comes at a time when markets are already extra jittery.

Market reaction has been unusual. The dollar tends to do well in periods of heightened geopolitical risk aversion as foreign investors seek the safety and liquidity of long-term Treasuries. However, that is not the case right now. Treasuries have declined, with the 30-year yield trading above 5% and 10-year yield trading above 4.50%. Part of this rise in yields could be due to fiscal concerns. As written, President Trump's “One Big Beautiful” tax and spending package is estimated to substantially add to the deficit, even when accounting for possible tariff revenue.

Fed officials continue to set up an extended pause. Bostic said "These things could lead me to maybe have to push out the time that we could get to a more normal posture because I think it would take longer for things to resolve." Musalem said "A look-through policy has risks and costs. Committing now to ignoring higher inflation from tariffs, or to easing policy, runs the risk of underestimating the level and persistence of inflation." Kashkari said “It’s wait and see until we get more information.” Hammack said “Right now I think the best action we can take is to sit on our hands and really carefully go through the data, engage with our communities, hear what they’re thinking about, hear about the choices that they’re making and see how that all comes together in the aggregate data.” Barkin and Bowman speak today. The odds of a June cut have fallen to nearly zero, around 25% in July, and less than 80% in September. Looking ahead, the swaps market is still pricing in 75 bp of total easing over the next 12 month, down from 125 priced in earlier this month.

Canada April CPI data ran hot. Headline came in a tick higher than expected at 1.7% y/y vs. 2.3% in March, while core median came in three ticks higher than expected at 3.2% y/y vs. 2.9% in March and core trim came in three ticks higher than expected at 3.1% y/y vs. 2.8% in March. As a result, Canada now faces greater risk of stagflation. The BOC’s scenario analysis shows Canada’s real GDP growth either stalling in Q2 or contracting over the remainder of 2025. Risk of stagflation will complicate the Bank of Canada’s easing cycle and undermine CAD on the crosses. For now, markets see less than 30% odds of a cut at the next meeting June 4.

EUROPE/MIDDLE EAST/AFRICA

U.K April CPI ran hot. Headline came in two ticks higher than expected at 3.5% y/y vs. 2.6% in March, core came in two ticks higher than expected at 3.8% y/y vs. 3.4% in March, and CPIH came in two ticks higher than expected at 4.1% y/y vs. 3.4% in March. The acceleration was due largely to higher energy and water bills as well as the impact of employer National Insurance Contributions. However, services CPI came in at 5.4% y/y vs. 4.8% expected and 4.7% in March. For reference, the BOE projected headline CPI at 3.4% y/y and services CPI at 5.0% y/y in April. Odds of a 25 bp cut in June are below 5%, rising to only 50% in August, while the swaps market is still pricing in around 50 bp of total easing over the next 12 months.

Sedlabanki cut rates 25 bp to 7.5%, as expected. This was the second straight 25 bp cut after two straight 50 bp cuts. The bank noted that “inflationary pressures remain,” adding that “Further interest rate cuts will depend on whether inflation moves closer to the bank’s 2.5% target.” Recall that April CPI data ran hot as headline picked up to 4.2% y/y vs. 3.8% in March, the first acceleration since July 2024 and back above the 1-4% target range. If inflation continues to run hot, we see risks of a hold at the next meeting August 20.

ASIA

Reports suggest market participants see no clear consensus on BOJ tapering. At the two-day hearings with the sell-side held by the BOJ, some banks are reportedly pushing for a faster pace of tapering, while others want a slower pace due to concerns about supply and demand at the super-long end of the curve. The planned hearing with the buy-side was held today but no reports have emerged yet. The BOJ is currently trimming its JGB purchases by JPY400 bln per quarter, with the aim of reducing its monthly purchases to around JPY2.9 trln by the spring of 2026. A decision will be made at the June 16-17 policy meeting. Given the recent turmoil in the JGB market, we expect the bank to maintain the current pace and underscore that it stands ready to make one-off purchases as needed to smooth market functioning.

Bank Indonesia cut rates 25 bp to 5.5%, as expected. It lowered its 2025 GDP growth forecast 0.1 ppt to 4.6-5.4% and expects inflation to remain low and stay within its 1.5-3.5% target range in both 2025 and 2026. IDR strength will be key in giving the bank confidence to ease further. Of note, Bloomberg consensus does not see the next 25 bp cut until Q4.

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