More urgent Fed may kibosh dollar forecasts yet again :Mike Dolan
It’s usually better for the dollar for the Fed to travel than arrive.
So the sooner the U.S. Federal Reserve pulls the trigger on what would be the first of a new cycle of interest rate hikes, only the fifth bout of multiple rate rises over the past 30 years, the more it will test the durability of the dollar’s surprising strength.
One of the big macro market misses of 2021 was the shattered consensus that this would be a year of dollar depreciation where the Fed let the economy “run hot”, with no rate rises likely until 2023 at the earliest.
Yet the dollar’s DXY index is sailing into year-end more than 7% higher than a year ago as few then saw just how overheated price rises would get and, more particularly, how irked the Fed would get by months of above-forecast inflation.
But a big question now is how much of this year’s anti-consensus dollar surge has already priced the coming Fed cycle – leaving an overwhelmingly bullish dollar take on 2022 at risk of being just as wrong as the 2021 view in reverse.
And getting that right matters a lot to global policymakers and investors alike – being a central ingredient in global financial conditions more broadly for the year ahead as well as pivotal in how emerging economies and markets perform.
World markets are on tenterhooks about Wednesday’s final Fed policy decision of the year, assuming inflation anxiety will double monthly tapering of its bond buying and underscore market pricing for two rate rises next year – starting in June.
Alongside easier settings from the European Central Bank and Bank of Japan this week, the bullish dollar show probably stays on the road with that outcome – according to most of the major forecasters, such as JPMorgan, Deutsche Bank and Goldman Sachs.
But what if the Fed nods that U.S. rate rises could begin as soon as March, as some of the more hawkish forecasts suggest?
This is where it gets trickier.
One rule of thumb used widely to gauge dollar behaviour is that its broad index typically gains about 4% over the 6 months before Fed ‘liftoff’.
Although it’s a crude averaging of different outcomes over time, doesn’t account for relative policy moves elsewhere and contains some exceptions, the broad assumption clearly makes timing of the first Fed move super important for the buck.
If there’s another 6 months to go, that ‘ready reckoner’ points at considerably more strength. But if it’s just 3 months?
‘LIFTOFF’ DATE TO ‘TERMINAL’ RATE
Curiously that 4% average gain is exactly how much the Fed’s broad dollar index has gained since June. The DXY index against major traded currencies has gained as much as 6%.
Just as important is what the dollar has done after the first hike.
After rising before the Fed kicked off its first hike in 1994, the DXY index then preceded to drop about 15% even as rates were ratcheted sharply higher through early 1995. In 2004, the dollar continued rallying in tandem with the early hikes, but turned tail 125 basis points below the peak in June 2006 and then fell more than 6% by the time the Fed finished tightening.
During the Fed’s 2015-2018 cycle, the dollar peaked just 3 rate rises into a 9-hike move – losing over 10% at one point before the Fed called it quits.
Just like the unexpected rollover of U.S. Treasury yield curve in the second half of this year, it clearly matters as much where the Fed is assumed to end its cycle as when it will start it.
And this too presents a puzzle – not least for those who assume the money markets and yield curves are getting it wrong right now and the dollar will continue to rise through 2022.
Paul Meggyesi and team at JPMorgan dwelled on this before the Fed decision this week and point out that the market has for some time this year simultaneously moved forward its liftoff date while cutting the ‘terminal rate’ where it sees it ending.
“At face value this flattening in the policy-curve and the broader yield curve reflects a pessimism not only about the economy’s cyclical resilience to a relatively modest tightening in policy but also the economy’s growth potential and hence ‘R-star’, they wrote, referring to the so-called R* interest rate that would theoretically exist were the economy at equilibrium with stable inflation.
But the JPM team rejected this money market ‘pessimism’, which sees a terminal Fed rate of less than 1.75% – still far below the 2% end-2024 indications from the median of Fed policymaker ‘dot plot’ forecasts and the Fed’s own assessment of a 2.5% ‘neutral’ rate.
In short, it reckons the full Fed trajectory is not yet fully priced by the dollar and it should “continue to grind higher into lift-off”.
What purchase in the money market the Fed might get from upping these ‘dot plot’ forecasts this week may now be key – revealing its credibility to some degree.
But a mirror image of 2021 for the dollar is not fanciful – with the new year consensus prevailing early on only to flounder in the second half. That would lead to what Morgan Stanley calls an ‘up-and-down’ year where timing is key and policy divergence favouring the greenback ultimately replaced with convergence by 2023.
Source: Reuters (by Mike Dolan, Twitter: @reutersMikeD; Editing by Alexander Smith)