The bearish USD argument
With each successive rate hike, the Federal Reserve has brought the policy rate closer to the level it identifies as the long-run equilibrium. Based on the Fed’s dots projections, this lies somewhere around 3.00%. A couple of more hikes and policy will most likely have peaked.
The Fed has already acknowledged this by no longer characterising policy as accommodative, suggesting the end of the rate hike cycle is near. Fed policy will soon be symmetrical whereby a rate hike will be as likely as a rate cut.
One only has to look at the sharp decline in the NZD when the RBNZ made a similar shift in rhetoric from hawkish to symmetrical to see what this will mean for the USD. Emerging Markets currencies will thrive in this environment, while the EUR would also rally strongly as the ECB embarks on its tightening policy soon after the Fed has called a halt.
Pushback – Why this argument does not withstand
There is a specious appeal to the idea that the USD must reverse lower because the Fed is nearly done with its tightening cycle while others are only just beginning. However, while the Fed Funds rate may be moving closer to long-run dot, it is still 75bp away from the current median projection for long-term rates
The market is only priced for 55bp of tightening by the end of 2020 according to Fed Funds futures and lower still for 2021 based on the OIS curve (Overnight Index Swap). So that means we are not quite priced for ‘neutral’. Such a gap to neutral might not point to dramatic upside for the USD, but it is hard to say it warrants USD selling.
The bigger hole in the bears’ argument is that it relies on an assumption that the neutral level of rates will be the same as the peak level of rates. This seems a strange assumption given what the Fed is telling the market. Perhaps the Fed will be proven wrong and not get to tighten as much as planned. But the Fed stuck to its path in 2017 despite inflation often coming in below expectations. It has stuck to the dots in 2018, and even raised them in some instances.
The Fed are telling us what they think they will end up doing with policy. We still believe the Fed will raise rates three more times and it way too early for FX to price in a significantly different outcome in our view. Markets are by their nature forward looking. But we do not expect the USD to fully price in a lowering of US rates which may or may not happen in a year’s time or more.
We believe it is much more plausible for the USD to reflect the hikes that are on the cards in the coming months, rather than the cuts which are possible but far from certain much later out.
Another equally important argument is around the level of rates
US one year rates are the highest in G10. So one gets paid to earn the US risk free rate with little duration risk. It is possible that this is about levels and not just rate of change.
We remain similarly unconvinced by arguments that monetary tightening outside of the US will suddenly provide the catalyst for a USD reversal lower. The ECB has signaled rates will stay where they are at least through the end of summer 2019. Lower than expected core inflation and lacklustre growth continue to raise questions as to when this eventual normalization might begin. Elsewhere, we have our doubts about whether Canada can match the pace of hikes currently priced into the market.
Our expectations for the timing of other central bank hikes in G10 have been pushed ever further into the future and those that do deliver are likely to tighten even more gradually than the Fed has done. The US has seen the greater shift in terminal rate expectations among G10 currencies, helping to explain its strength.
So the direction of travel on rates remains in favor of the USD. The pricing for the US rate profile could be too dovish. In addition, the level of US interest rates favors the USD. Simply put, a bearish case for the USD based on rates does not stack up in our opinion.