US Dollar setback after the FOMC, followed by a rebound
US Dollar setback after the FOMC, followed by rebound. We expect the Fed will raise rates at its December meeting (on Wednesday), but the tone of the statement and Chair Yellen’s press conference will be more neutral than previous rhetoric from Fed Governors, forcing the US Dollar (USD) lower.
As a result of more toned down Fed rhetoric, we expect that the USD could experience a near-term setback on a ‘buy the rumour, sell the fact’ move after its second rate rise in its current tightening cycle. While a rate rise is currently fully priced in, we feel the market is overpricing the chances of the Fed raising its ‘dot plot’ for next year. We believe the Fed will retain the same ‘dot plot’ for rate hikes in 2017 (currently two hikes predicted) and strike a more neutral tone in its statement and at Chair Yellen’s press conference. With the Fed willing to run a ‘high-pressure’ economy next year, we expect the USD to suffer in Q1 as the central bank begins to lose its inflation fighting credibility.
Strong economic data, particularly the ongoing buoyancy of the jobs market has driven the US Dollar higher in recent months against all G10 currencies. Investor positioning has surged since mid-October and is at the highest level since August 2015. This could quickly unwind – on a real yield differential basis the USD is currently beginning to look stretched against G10 currencies.
With Trump policies likely contributing to inflationary pressure, alongside higher wage growth and upwardly trending core inflation factors like healthcare and housing, we feel the Fed will need to change its projections and be more aggressive in its tightening profile than what is currently envisaged. As the Fed comes to terms with having to be more active with monetary policy in mid-2017, we feel the USD could stage a rebound in the second half of the year.
Martin Arnold, Global FX & Commodity Strategist at ETF Securities
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.
Introducing core FX investment strategies In 2005, Rydex Investments launched the first ever currency ETF called the Euro Currency Trust (NYSE Arca: FXE) in New York. Since then Rydex has launched a series of funds tracking all major currencies under their brand CurrencyShares.
In 2007 Deutsche Bank’s db x-trackers launched EONIA Total Return Index ETF in Frankfurt tracking the euro, and later in 2008 the Sterling Money Market ETF (LSE: XGBP) and US Dollar Money Market ETF (LSE: XUSD) in London.
In 2009, ETF Securities launched the world’s largest FX platform tracking the MSFXSM Index covering 18 long or short USD ETC vs. single G10 currencies. The funds are total return products where the investor gets access to the FX spot change, local institutional interest rates and a collateral yield.
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Near-Term Risk of USD Sell-Off on FOMC Tonight’s FOMC meeting could provide a short-term opportunity to short the USD against major G10 currencies (EUR, GBP, JPY, CAD). However, we remain structurally bullish on the USD in the medium term.
The risk for USD could come via two avenues: the external environment affecting domestic growth and/or inflationary expectations. Either could see the recent USD strength unwind.
The FOMC is likely to continue to highlight the improvement in the domestic economy. However the Fed has a dual mandate and either could prompt a downside move in USD.
If either are highlighted, the market is likely to push back expectations for a rate hike further into Q3/Q4. At the moment, expectations are for a rate hike in September.
The FOMC has already emphasised the gradual nature of any future tightening cycle and if it stresses a slowing growth or a softer jobs outlook due to problems abroad, it is likely to be reflected in more cautious language about the upcoming tightening cycle. A potential negative feedback loop from risks to growth in the rest of the world could come from many areas: increasingly divergent political situation in the Eurozone alongside moribund growth in the periphery and Japan, geopolitical risks or the impact of a stronger USD on corporate earnings.
The inflationary environment has been relatively benign despite improving economic activity. The FOMC previously noted the impact of lower oil prices on inflation would be transitory, so any indication that there could be longer lasting effects would see rate hike expectations unwound. Indeed oil prices were on of the reasons the Bank of Canada surprised the market by cutting rates. Meanwhile wage growth remains soft and house price growth has moderated recently. As a result, any indication that inflation may not return to target as quickly as expected could also postpone a rate hike from the Fed.
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