With the Fed on the rate rise trail, what path for the dollar?
In a matter of days, the US bond market has noted changed tones from Federal Reserve officials and has quickly repriced the chances that the US central bank will raise interest rates in March.
However, how the currency markets will see the US dollar’s consequent trajectory remains to be seen.
Investors with long memories may recall that the multiple rate increases begun by the Federal Reserve in February 1994 were actually accompanied by weakness in the American currency. The dollar’s index value versus a basket of major trading partners’ currencies fell to 80.8 in June 1995 from 91.1 when the Greenspan Fed started raising the rate.
That doesn’t mean the dollar should now trend down. This is not 1994. But it perhaps does mean that investors should not necessarily assume that from this point the dollar will uniformly rise in value as the Fed rate goes up.
Fed Chair Janet Yellen does sound more hawkish, saying on Friday that “at our meeting later this month, the committee will evaluate whether employment and inflation are continuing to evolve in line with our expectations, in which case a further adjustment of the federal funds rate would likely be appropriate.”
Nevertheless, even if a March increase suddenly seems set in stone, the currency markets may yet take a more nuanced view of how that should be reflected in dollar strength.
Derek Halpenny, European head of global market research at Japan’s Bank of Tokyo-Mitsubishi UFJ (BTMU), wrote on Thursday that “a [US] rate hike as soon as this month is now viewed as almost a done deal” and that the fixed income market “can no longer be as complacent over the prospect of tighter monetary policy.”
But, Halpenny added, while “the developments are clearly supportive for the US dollar” the greenback “has strengthened only modestly so far.”
BTMU feels this is partly explained by the fact that “the Fed’s trade-weighted US dollar index against the other major currencies has already strengthened by almost 40 per cent” over the last six years, concluding that “the hurdle for further US dollar strength now appears higher.”
London-based Eurizon SLJ Capital’s Stephen Li Jen, also writing on Thursday, ascribed the fact that “the dollar has not been trading well in recent weeks” to “the rest of the world … performing just as well as the US has” and to “dollar-negative rhetoric from some of the officials from the Trump administration.”
Nevertheless Jen still believes that the attractions of the greenback over other currencies will still win out and thinks it is right to “be patient with the dollar.”
But even if Jen is right and the dollar ultimately clears the higher hurdle that BTMU alluded to, there is still the question of whether a further dollar rise would be general or selective.
Selective greenback strength was even evident during its more general fall in the dollar index in 1994-95.
Most notably, the greenback eventually soared versus the Mexican peso as higher US rates encouraged capital flight out of Mexico’s currency into the dollar and ultimately forced Mexico to devalue its currency in December 1994, triggering the so-called “Tequila Crisis” and January 1995’s US-led US$50 billion bailout of Mexico.
As for 2017, with another Fed rate rise seemingly imminent, traders might naturally see value in the dollar versus the yen given that while the US central bank is in hiking mode, the Bank of Japan certainly is not. Time will tell.
If the currency markets feel the Fed’s actions will affect US consumption, and given the time-lag before Trump’s economic stimulus plans kick in, commodity currencies such as the Australian and Canadian dollars might slip against the greenback.
Given the scale of American consumers’ appetite for Chinese goods, the currency market might even target a weaker yuan versus the dollar, which could then could have a knock-on effect on the euro/dollar and dollar/yen exchange rates.
With China managing the yuan on a basket basis, in a circumstance where the bilateral dollar/yuan rate was rising, currency markets might assume Beijing would prefer a counterbalancing rise in the yuan’s value versus the euro and the yen to maintain the yuan basket’s stability.
If so, traders might then act on an assumption China could be a natural buyer of dollars against both the euro and the yen as the way of maintaining that stability.
The foreign exchange market may well conclude that, unlike in 1994-95, Fed rate rises in 2017 lend themselves to further dollar strength. But just because the Fed is back on the rate-rise trail doesn’t mean the currency market will blindly buy the greenback.