The U.S. dollar has enjoyed a robust rally over the past seven months. An economy growing above potential rate, fiscal stimulus, low unemployment, above target inflation, diverging monetary policies, emerging market troubles and recent signs of rising wage growth were all factors that propelled the U.S. currency higher. Yet, the bullish run stalled in mid-August with the dollar’s index retreating 2.8% from its 13-month high.
The pullback over the past five weeks suggests that most of the positive news has already been priced in, including the rate hike which is expected to take place tomorrow followed by another one in December. This led speculators to pare some of the bullish bets on the dollar, especially that several central banks seem to follow the Fed’s path in tightening policy.
According to CME’s FedWatch, traders are expecting a 100% rate hike tomorrow and an 83% probability for another hike by year-end, which is in line with the Fed’s dot plots from June’s meeting.
The Federal Reserve may not seem very worried about growing tensions with the global trade dispute. So far there are no clear indications that global trade tensions are weighing on the U.S. economy despite a couple of surveys showing that some businesses are considering reassessing their investment and hiring plans. As for the inflation threat, the latest 10% tariff on $200 billion worth of Chinese goods is expected to have a minimal impact on prices, especially given the decline in the Chinese Yuan. However, this assessment will change if a 25% tariff is imposed on all Chinese imports, however the Fed won’t jump to conclusions at this stage.
The most interesting part in this scenario is how the Federal Reserve sees the economy performing in 2019 and beyond. Ongoing support from the fiscal stimulus will gradually begin to fade and higher borrowing costs along with a stronger Dollar will likely begin impacting future corporate earnings. For 2019 it only takes one member to lower his or her interest rate projections to shift the median expectation to two rate hikes instead of three. Such a shift in the dot plot will be viewed as dovish and likely lead to further selling pressure on the dollar.
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