Over the past six months, we’ve seen a notable shift in US interest rate expectations. Back in September 2018, the market was expecting three rate hikes from the Fed in 2019. By November, this had fallen to two hikes and at the time of writing the market has fully priced in a 25-basis point rate cut by the end of 2020 (with a 53% probability of a cut by the end of 2019). Conventional wisdom would lead us to thinking that the impact on the dollar should be negative (since a lower yield or even expectations of a lower yield, makes the dollar less attractive to investors).
However, a quick look at a chart of the US Dollar Index below shows that on a trade weighted basis, the dollar has been remarkably stable over the past year and if anything, has made a small advance in recent months.
Chart 1: USD INDEX
Clearly looking at the dollar in isolation could be slightly misleading since currencies are typically quoted in pairs. Looking at the table below, a narrowing of the interest rate differential between the euro and the dollar should theoretically have been positive for the euro (as it has for sterling). However, a widening of the differential between the Australian dollar and the US dollar (in favour of the AUD) should have been positive for the AUD. In contrast, the AUD has fallen almost 2.9% against its US namesake during the past four months. Clearly there must be other factors at play.
TABLE 1: Interest Rate Differentials (for a USD fund hedging foreign currency exposures)
One possible explanation is that the risk on / risk off relationship that was the primary influence driving currency markets during the financial crisis is coming back into focus. This would explain why the Australian dollar has under performed while the Japanese Yen has done so well. However, if this were the case, the Swiss Franc should have done better while sterling would likely have come under greater pressure. Additionally, there aren’t obvious signs of distress elsewhere with equity markets across the globe advancing so far this year.
A second justification for the mixed performance of the dollar is that country specific factors are having greater influence than rate differentials. For example, in the UK, Brexit negotiations have been centre stage in recent months while other, more traditional influences have been considered secondary (the theory being that whatever happens with Brexit will govern economic performance in the years ahead).
Meanwhile look at the latest composition of foreign exchange reserve (COFER) data from the IMF shows that central banks have been net sellers of USD in the past three quarters and net buyers of EUR and JPY in similar size. However, positioning data from CFTC shows the opposite suggesting that the speculative market is positioned otherwise.
The options market (risk reversals) shows traders there are relatively neutral on all the major pairs with the obvious exception of sterling where GBP puts are significantly more expensive than GBP calls. This is hardly surprising given uncertainty caused by Brexit, but the lack of directional bias elsewhere tells its own story.
In conclusion, there are multiple factors at play and identifying one key driver for all currencies is impossible at the moment and makes forecasting currencies extremely difficult. The fact that narrowing interest rate differentials haven’t negatively impacted the dollar (particularly against the euro) add confidence to our overall bearish stance on EURUSD (for the time being at least!).
Author: Marc Cogliatti