FX Monthly – Fed cycles and the dollar

by: Georgette Boele

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The Fed’s exit has become the dominant theme in markets

Financial markets have once again started to fret that the Federal Reserve will reduce its monetary stimulus. In this monthly we assess the impact of the withdrawal of stimulus on the dollar and other currencies with the help of an analysis of past economic cycles. Our central view is that the Fed will announce a tapering of its asset purchases in two steps – December of this year and March of next year – with the asset purchase programme coming to a halt by the middle of 2014. We expect the first Fed rate hike in early 2015. While we judge that financial markets are far advanced in pricing this central scenario for tapering, we judge that there is much further to go in terms of building in expectations of higher short-term interest rates. We judge that the adjustment of tapering expectations will run its course this year, while rate hike expectations will significantly rise from around the middle of next year.

Expectations of higher official rates have generally supported the dollar in past cycles

We have looked at the behaviour of currency markets following the pricing in of monetary tightening ahead of seven past rate hike cycles. On average, during these cycles, expectations of higher interest rates have been modestly supportive for the US dollar. Only a few currencies have been able to swim against the tide: the Mexican peso, the Japanese yen and the Australian and New Zealand dollars. At the same time, the US dollar’s performance has varied significantly between cycles, reflecting economic fundamentals for the US economy and the way in which they interacted with higher US rates. We distinguish between different cycles. There are ‘good’ Fed tightening cycles characterized by a combination of strong US growth, low inflation, favourable developments in the fiscal and external balance, and a gradual removal of policy accommodation, and ‘bad’ or ‘neutral’ cycles where developments are less favourable. Good ‘Fed cycles’ have seen the dollar rally strongly, with the trade-weighted index up by more than 10% from the point where expectations of tightening built.

We see the dollar rising in two waves

We think we will soon enter such a ‘good cycle’, which should be characterised by dollar strength. US demand growth will be relatively strong, imbalances should ease, while low inflation gives the Fed breathing space. Dollar strength will probably come in two waves. In the first wave – over the next 6-9 months – a strengthening US economy will support the dollar versus the euro and other majors, while also reviving carry trades. The second wave of dollar strength will be more broad-based and will come on the back of the anticipation of rate hikes in the second half of 2014, which should give the a strong push to the USD.