Economists are notorious for sitting on the fence and Federal Reserve (Fed) Chair Yellen is no different: her latest speech spent part of the time focussing on the possibility that the Fed underestimated the weakness of the price and labour market dynamics and the other part highlighting that policy shouldn’t move too slowly to offset potential inflation pressure. However, the more hawkish tone of Chair Yellen’s comments underpinned a rise in bond yields and the US Dollar (USD): two trends which we expect to continue. Is dovishness dead at the Fed?
We believe that on balance, that the Federal Reserve’s policy stance is becoming more skewed towards tighter policy. Chair Yellen highlighted that ‘low inflation is probably temporary’ and that ‘we should…be wary of moving too gradually’ in moving rates higher. She even made the case that higher rates are beneficial as it gives the central bank more firepower to support the economy in the event of a recession. Indeed, the Fed appears to be becoming more proactive with Chair Yellen noting that ‘it would be imprudent to keep monetary policy on hold until inflation is back to 2 percent.’
US real interest rates are continuing to trend higher, as nominal rates are outpacing the rise in consumer prices, as the market increasingly prices a greater potential a rate hike in 2017. We expect that this trend will remain supportive of a grind higher in the USD in Q4.
Currently the market is pricing in a 64% chance of a rate hike in December, up from 37% at the beginning of September. Indeed, there appears to be more upside for the USD, as investors remain somewhat pessimistic about the currency, despite the potential for higher rates (both real and nominal). Futures market positioning shows that net speculative positioning is at the lowest level in over three years, and well below longer-term averages. Moreover, options pricing indicates that only commodity currencies (Australian, New Zealand and Canadian Dollars’) are expected to be weaker than the USD over the coming month.
Dovishness is certainly not dead at the Fed, but the hawks are circling their prey. Accordingly, we expect that the changing policy stance at the Fed will see the USD bottom and grind higher against G10 currencies in coming months.
Martin Arnold joined ETF Securities as a research analyst in 2009 and was promoted to Global FX & Commodity Strategist in 2014. Martin has a wealth of experience in strategy and economics with his most recent role formulating an FX strategy at an independent research consultancy. Martin has a strong background in macroeconomics and financial analysis – gained both at the Reserve Bank of Australia and in the private commercial banking sector – and experience covering a range of asset classes including equities and bonds. Martin holds a Bachelor of Economics from the University of New South Wales (Australia), a Master of Commerce from the University of Wollongong (Australia) and attained a Graduate Diploma of Applied Finance and Investment from the Securities Institute of Australia.