US Dollar Gains Despite Fed Reticence, Is a Risk Shift Afoot?
Fundamental Forecast for Dollar:Neutral
- Following the Fed’s hold on rates, the market is pricing in only a 36 percent chance of a hike this year
- As markets flounder despite the Fed’s support of easing policy continues, the Dollar gains haven appeal
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The big day has come and gone. The Federal Open Market Committee (FOMC) voted 9-1 to keep the range for the benchmark interest rate between 0.00 and 0.25 percent. While this outcome was generally expected, the response from the market certainly wasn’t. In past years, policy decisions by the world’s largest central bank to maintain accommodation roused speculative appetite as opportunities would look to cover the insurance (‘just in case they hike’) premium. The sentiment boost combined with a more distance liftoff on rates for the Fed in turn would encumber the Greenback. That wasn’t the case this time around. Is complacency finally starting to fade? Will we once again see the rise of the Dollar’s haven demand?
Looking back earlier in the year to previous FOMC meetings. There was a very different market response to a status quo outcome than what we had seen this past week. In more distinct comparison, the June meeting (one of the quarterly events with the updated forecasts and Yellen press conference) ended with the central bank keeping the course. The currency response was a steep slide while capital markets climbed. While the constant reach for yield that gained so much prominence in previous years had cooled by that point, there was still a very active speculative appetite with a penchant for buying dips. The FX market was in turn sensitive to every ebb and flow in relative monetary policy expectations.
Since the June rate decision, we have seen a painful shock of risk aversion through mid-August and the focus on relative yield shift to relative risk. That has tempered the Dollar’s sensitivity to adjustments in timeline for the first Fed hike and shift the focus on the relative position of a hawkish central bank drawing greater contrast to a field of doves. Heading into last week’s meeting, the market was projecting an approximate 85 percent probability that the Fed would not lift rates, so the outcome generates limited surprise. Looking ahead, the chances of a December liftoff – there is also an October gathering but it will not be one of the quarterly events with updated forecasts – have declined from 70 to 36 percent.
Compared to the end of last year when the FOMC itself was forecasting 100 bps worth of hikes this year and the market was calling for around 50 bps of tightening, we certainly have a more dovish bearing for the Dollar. That said, the downgrade is arguably well-accounted for in the currency’s plateau over the past 6 months. A delayed hike is still a hike compared to rate cuts and QE programs for counterparts. Leveling off after a run may be the extent of that moderation.
It is important to remember that value in the FX market is a relative evaluation. If the capital markets falter despite the Fed’s hold, other central banks that have struggled with their economies and/or financial systems may feel they have to compensate for the lost support and ease themselves. That would indirectly leverage the Dollar’s fundamental appeal. So, with an eye on ‘risk’ benchmarks, Dollar traders should also keep tabs on important event risk on the docket of the other majors. Among key releases are global PMI figures, Japanese CPI and ECB Draghi’s quarterly testimony.
Relative gains on monetary policy divergences is still the most active fundamental driver in the FX market. However, the greatest potential for volatility and momentum rests with the more elemental investor sentiment theme. If investors are no longer satisfied to participate in status quo bids for short-term gains, there is considerable thematic and notional leverage that will be at risk of deleverage. For conviction, if the S&P 500 extends its dive from four weeks ago, we will see a shift in focus and rolls. No longer will we look at the Dollar for a 25bp future yield advantage. Rather, we will see the Greenback as the market’s most prominent harbor from violent financial storms.