The US Dollar has always been a very interesting and influential currency. After all, it’s the world’s reserve currency and the majority of all transactions on the planet are made using dollars. The dollar tends to run in long-term trends and the past 12-18 months of broadly sideways action suggest that it’s consolidating before the next big move. The million dollar question is: which way next?
The Federal Reserve held rates in September but clearly indicated that they will most likely hike by year-end. Yellen explicitly stated that the case for a hike had strengthened significantly. The market is currently pricing over 50% chance for a December hike but what’s really at stake now is not the next 25bps; it’s the Fed’s credibility. If they don’t hike in December the market will get very disappointed and essentially it may start to ignore the Fed members’ statements & forward guidance. After all, it will have been a year since the last hike and although Fed speak has been quite hawkish, there seems to always have been a reason for them not to pull the trigger again. Clearly this would be a huge blow for the Fed and the US dollar.
On the other hand, if the Fed hikes in December, it will place a bigger burden on the US’s slow economic recovery. It’s been almost 8 years since the financial crisis and even though the massive scale of economic stimulus has been unprecedented, the US economy has only managed a relatively weak trajectory so far. Some of the data has been impressive but if you look at the details it can look fragile. A good example of this is unemployment – the headline rate is very low and suggests a booming economy, but if we consider the LFPR drop and job quality trend, the picture looks quite different. Other important economic indicators (such as inflation and GDP) keep getting revised lower and this puts even more doubt in Fed members’ minds.
It’s likely that the December FOMC meeting will be the trigger for a move but it’s not just the rate decision that will be the market mover. It will be equally important to see what the tone of the post-meeting talk will be. They could easily deliver a 25bp hike but make a more dovish than expected statement. Given that the market is pricing a further couple of hikes, one can easily see a scenario where a dovish hike causes the dollar to weaken. Expectations for the long-term interest rate equilibrium level (the infamous “dot plot”) have been steadily lowered so the market may be overestimating the level of neutral rates. On the other hand, the strong unemployment and payroll data may give Yellen the confidence to push for a more aggressive hiking cycle and this will also surprise the market. The 10year UST yield is at around 1.70% and this indicates that the market certainly doesn’t expect rates to be moving materially higher in the near term.
In summary, it’s fair to say that the dollar is at an important junction. It takes guts to go against the world’s biggest economy, especially since it’s currently the only major western economy that’s in a theoretical hiking cycle. There are valid arguments to support a continuation of the Fed’s (shallow) hiking cycle and they cannot be ignored. On the other side, the risk of a further US economic slowdown is still high and could easily disappoint market expectations.