High inflation and hawkish signals strengthen rate hike bets, the US dollar holds near two-week highs, and Deutsche Bank warns stock market reliance on capital may suppress exchange rates

According to the Zhihui Finance APP, during early Asian trading on Wednesday, the US Dollar Index held its gains, hovering near a two-week high. A higher-than-expected inflation report and hawkish remarks from Federal Reserve officials have strengthened market bets on a rate hike by the Fed next month.

Data shows that the US Dollar Index, which measures the strength of the dollar against a basket of six major currencies, remained steady at 102.22, close to its highest level since October 28. The euro and pound were unchanged against the dollar at 1.1168 and 1.3345 respectively; the dollar was steady against the yen at 158.715; the Australian dollar rose 0.1% to 0.6870, slightly rebounding from a seven-month low; and the New Zealand dollar was unchanged against the US dollar at 0.5605.

Chris Weston, Head of Research at Pepperstone Group Ltd. in Melbourne, said that the interest rate market is not just pricing in another rate hike, but is questioning how restrictive US monetary policy may ultimately need to be, which is a more significant debate for risk assets.

In the previous trading session, the index rose 0.5% as the US October Consumer Price Index increase exceeded market expectations, driven by higher food and accommodation costs; meanwhile, Federal Reserve Governor Waller stated that a 50 basis point rate hike in December could not be ruled out.

Fed voting members responsible for setting interest rates expressed unease over high inflation, further solidifying market expectations for continued rate hikes and prompting traders to almost abandon bets that the Fed will hold rates steady at the next policy meeting ending December 9.

According to the CME Group's FedWatch tool, federal funds rate futures currently show a 90.9% probability of a 25 basis point rate hike next month, up from 84% the previous day. The market has fully priced out the possibility of a rate pause, seeing just a 9.1% probability for a 50 basis point hike, while assigning over 50% odds to a second rate increase in January next year.

The yield on the US 10-year Treasury note rose by 13.8 basis points to 4.996%. In the cryptocurrency market, Bitcoin fell 0.3% to $73,566.45, and Ethereum fell 0.5% to $2,044.61, with both trading near three-month lows.

Reliance on equity inflows may weigh on the exchange rate

While short-term rate hike expectations continue to support the dollar, Deutsche Bank strategists warn from a capital flow and hedging perspective about medium-term pressures facing the greenback.

Strategists, including George Saravelos, Global Head of FX Research at Deutsche Bank, noted in a report that the US dollar’s reliance on equity inflows is increasing, which may erode the diversification benefits from holding unhedged US assets and over time impose downward pressure on the dollar.

The report explained that historically, foreign investors benefited from the characteristic that the dollar often strengthens when US equities decline, providing a buffer against losses; however, as the correlation between the dollar and stock market sentiment grows, this negative correlation is gradually breaking down, which may prompt foreign fund managers to increase their dollar hedging ratios, thus suppressing the greenback.

Deutsche Bank examined the US dollar hedging ratios of pension and life insurance companies from more than ten countries. The report showed that some countries and regions, such as Sweden, Switzerland, and the Eurozone, still hold relatively high dollar exposure, while others like Chile, Canada, and the United Kingdom have made significant adjustments.

The strategists stated that further changes in the correlation between the dollar and equities will become a key driver of future hedging decisions. However, the report also pointed out that although the weakening negative correlation is diminishing the diversification benefits of unhedged dollar assets, higher hedging costs and lower FX volatility still encourage investors to maintain their dollar exposure.