What Next for the Dollar?
The Fed’s decision to raise rates by 25bp last week was not a surprise; expectations for a hike increased to 94% in the week or two prior to the decision (as we referenced in the Big Picture published on 6th March). USD strengthened by almost 3% relative to GBP and CAD respectively in the 2-3 weeks leading up the announcements as the Fed robustly managed expectations as to what was coming.
Upon release of the announcement some of this gain was given back immediately in a classic example of “buy on the rumour, sell on the fact”. USD immediately fell by more than 1% relative to EUR and CAD respectively and has continued to soften against GBP. This reaction is consistent with a market that fully ‘priced-in’ the headline event. As participants look at what is coming next the associated commentary around the decision was not enough to drive the market higher, with lack of a major catalyst in the short-term, traders saw the opportunity to take profit.
Even after the correction, the table below demonstrates how two of the key currency market indicators we monitor still show contrasting signals.
|PPP Valuation||Extremely Bullish||Bullish||Bearish|
From a technical perspective, momentum is still strong for USD relative to GBP and CAD, suggesting in the short term the trend will continue (for calculation methodology details of both indicators please see page 8). However, the longer term valuation indicator suggests over-valuation of the dollar for all three pairs; GBPUSD and EURUSD are respectively 15.9%, 4.6% undervalued, whereas USDCAD is 9.8% overvalued. Considering this overvaluation there is potential for a large weight of money to flow against it if the trend begins to change.
The key driver of the divergence between momentum and valuation indicators has been the interest rate differential, also known as “Carry”. The big story of the last year has been the ability of the US to start tightening rates, whilst other major economies continue to struggle and remain constrained with fragile economies leading to accommodative policy.
Central Bank Bias:
|Current Rate||Last Change||Date of Change||Next Meeting||Likely Next Move|
|UK||0.25%||-0.25%||4th August 16||11th May 17||Unchanged|
|US||0.75%-1.00%||0.25%||15th March 17||3rd May 17||Unchanged|
|CAN||0.50%||-0.25%||15th July 15||12th April 17||Unchanged|
|EUR||0.00%||-0.25%||10th March 16||27th April 17||Unchanged|
The US economic recovery has provided the Fed with the ability to move towards a more normal monetary policy and start to raise rates. As shown in the above table, the Fed is the only major economy to begin tightening. The question for currency markets is whether the next few years will see gradual catch-up by other central banks, or whether the US can accelerate growth, leading to inflation and therefore interest rate rises beyond current expectations.
The previous administration oversaw the start of the economic recovery and recent talk of fiscal stimulus and domestic focus has raised hopes that the American economy will be great again (i.e. trend GDP growth + 4%). However, timing is often uncertain in financial markets and the impact of political factors make the future even less easy to predict. The current geopolitical environment feels particularly fractious with tail risk surrounding Brexit, Euro-break-up, Trump’s presidency and the oil price all having potentially significant impact.
Markets are currently pricing in 2 further rises from the Fed by the end of 2017 whilst expectations in Europe, UK and Canada are for no changes for the rest of the year. All things considered, I would suggest that rate rise expectations are quite aggressive for the US indicating greater downside risk for the dollar if they are not met. Further support to this view could come from strength in other regions, if economic green shoots are sustained and EUR, GBP and CAD rate rises can exceed expectations.
Author: Alexander MacAndrew