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Dollar Weakness is In Vogue; but For How Long?

Dollar Weakness is In Vogue; but For How Long?

James Stanley, Strategist

Talking Points:

- The US Dollar continues to drop below support levels, and this has helped many risk assets continue rallies; but the big question is how long USD weakness might persist, and this will likely be driven by Fed rate hike expectations; which we will receive next week at the upcoming FOMC meeting.

- While markets are currently pricing-out rate hike expectations for 2016, the Fed has shown a persistent drive to try to kick rates higher, even in the face of numerous hurdles. There is likely a reason for this, and with stock prices remaining near highs, the bank may not be far away from surprising markets with a hawkish stance in next week’s economic projections.

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In yesterday’s article, we looked at the thrust lower in the US Dollar on the heels of Friday’s NFP report. On Monday, Chair Yellen spoke in Philadelphia and the takeaway was that the bank likely wouldn’t hike while questions still revolve around employment in the American economy, and this only drove the US Dollar lower. This was a stark contrast to May’s price action in USD as we saw rate expectations climb throughout the month, creating a strong rip higher in the US Dollar. But the past week has brought an out-sized reversal as this reality that markets will likely have to wait a bit longer to get another actual rate hike out of the Fed.

Dollar Weakness is In Vogue; but For How Long?

Created with Marketscope/Trading Station II; prepared by James Stanley

But the question remains: Is this a lasting move in the Greenback? As in, the Fed surely doesn’t want to hike in the face of declining data when numerous questions already exist to the strength of the American economic recovery; but there’s a reason that they’ve been driving for higher rates for over a year now while there are some very big global macro questions. China’s stock market began to implode about a year ago, and this seeped into global markets in August after the PBOC staged a stark devaluation of the Yuan. Oil prices were getting slaughtered for much of last year, and the commodity space in general was feeling a considerable amount of pain, yet the Fed continued to talk up the prospect of higher rates. These risks were clear, and the Fed surely saw them yet continued to try to drive rates higher.

And even after that first rate hike in nine years that the world saw in December, the Fed continued to talk up the prospect of a full four rate hikes for 2016 even in the face of this flurry of economic risks. And it’s key to point out, despite any perceived missteps of the past or any criticisms that have been offered, the Fed isn’t completely disconnected from markets; so we’d have to assume that there is a motivation at the bank, of some kind, to drive rates higher. What that motivation is remains to be seen, but deductively one could suspect that the bank is trying to avoid a deflationary spiral similar to what was seen in Japan post-1990.

Dollar Weakness is In Vogue; but For How Long?

Created with Marketscope/Trading Station II; prepared by James Stanley

As baby boomers continue to retire out of the workforce, low rates become more and more of a nuisance to growth as these investors are forced to either a) invest in fixed income at extremely low rates, with the risk of the value of that portfolio getting crushed in a rising rate environment or b) take on way more risk than they normally would by investing in assets such as stocks in the attempt of finding that extra return. But not only do individual investors have issues in low rates environments, as pension funds and defined-benefit plans are forced to looked for yield in a world with very little to offer. And these investors (pension fund managers) are faced with the same set of abysmal options facing individual retirees: They can either invest in fixed income while rates are extremely low, taking on the risk that the value of those bonds will become worth-less in a rising rate environment, or they can look for extra return by taking on more risk.

So this is a very valid reason for the Fed to want to drive rates higher away from ‘emergency-like’ policy. And deductively, this makes sense as to why the Fed continues to talk up higher rates even in the face of the numerous global risks that the world is currently contending with. But this goes back to the original question: Is this move lower a lasting move in the US Dollar? And for the answer to that question, we should refer back to the ‘Fed Feedback Loop.’

The Fed Feedback Loop is the idea of the Federal Reserve shaping rate expectations around equity markets. As equity markets rally, the Fed gets more hawkish and talks up the prospect of higher rates, much like we saw in May as the US Dollar put in aggressive price action to factor in those comments from numerous Fed members. But those higher rate expectations have had a tendency to add pressure to markets, much like we saw in December leading into January; and as that pressure build and begins to show more prominently, the Fed responds by getting more dovish towards future rate hikes. This provides support for markets around the idea that rates will stay ‘loose for longer,’ which has had a tendency to stoke another risk-rally, which, in general, lasts until the Fed goes hawkish again.

If we are truly seeing the Fed take on a more dovish stance towards rate hikes moving forward, we’ll likely see USD-weakness continue until the bank begins to get hawkish again. And one week from today, we have the next FOMC meeting in which the bank will release economic projections for the quarters/years moving forward, and this is also where we’ll get the updated ‘dot plot matrix.’ Should the Fed moderate their previous stance of looking for two rate hikes in 2016, USD weakness could continue on this backdrop of more passive monetary policy.

But if the Fed does hold the line on two rate hikes for 2016, which, as long as stock prices remain near highs is a distinct possibility given recent history and motivation for the Fed to drive rates higher, and we can see the US Dollar begin moving right back up in anticipation of a potential move in July or September.

For now, USD weakness is in vogue as markets have zero expectations for a move next week. But markets are always forward-looking, so what the bank releases in terms of their economic projections at this next meeting will likely be that next ‘big driver’ in the greenback, and this will likely continue to carry repercussions across markets and asset classes. But traders should be on guard for a hawkish surprise in terms of economic projections from the Fed as long as equity prices remain elevated.

Dollar Weakness is In Vogue; but For How Long?

Created with Marketscope/Trading Station II; prepared by James Stanley

--- Written by James Stanley, Analyst for DailyFX.com

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