Article / 31 May 2016 at 9:00 GMT

Dollar gains treated differently this time

Head of FX Strategy / Saxo Bank
  • This week's data crucial for dollar rally
  • Markets 'no longer afraid of the Fed'
  • USD bulls should watch negative real rates

Columbus Circle, Manhattan
This week's data releases will show whether theUS economy is keeping pace 
with the hopes of both dollar bulls and the Fed. Photo: iStock 

By John J Hardy

This is a critical week for testing the strength of the recent USD rally as a stream of Federal Reserve comments have clearly laid the groundwork for a summer rate hike at either the June or July Federal Open Market Committee meetings. 

The Fed rhetoric – talking up the prospects of two or even three interest rate hikes this year – was clearly coordinated and designed to move markets' expectations for rate hikes higher. The Fed did this because it wants the luxury of acting on rates without unduly surprising the market with a more hawkish stance – figuring it was better to talk up potential hikes and then link that potential to the quality of incoming data. 

That data dependency, then, makes this week's key US releases this week that much more likely to generate near-term volatility as the market shifts the odds fo  a June, July or September rate hike. 

(We could even see talk of hike in June and September if the US data really kick into high gear this week and for the June data cycle).

But while the Fed rate hike debate has dominated headlines (and perhaps dominates the hour-to-hour action in currency markets), another interesting development over the last week was the market’s apparent declaration that it is not afraid of the Fed. 

When Fed officials began talking up their more hawkish outlook the week before last, global risk appetite was cowed into submission, with emerging market currencies and equity markets dipping sharply. This, of course, is what they have done at every sighting of a Fed hawk and USD strength since the May 2013 “temper tantrum”, when former Fed chair Bernanke merely mentioned the idea that one day the Fed would begib slowing the rate at which it would expand its balance sheet by tapering asset purchases. 

But last week, global markets bounced back strongly from their prior funk and the US S&P 500 index is even within a couple of percentage points of its all-time highs. The MSCI world index –even the USD-denominated one – rebounded an impressive 2% last week.
What does this mean? At times this year, investors have been convinced that even the one interest rate hike last December was too much for global markets to stomach. Now we have the Fed explicitly talking two to three hikes and yet asset markets charge higher? 

Perhaps all of this points to the idea that whether the Fed’s key rate is 0.5% or 1.00% doesn’t even matter and that monetary conditions globally, given the Japanese and European central banks' ongoing massive money printing and China’s fresh stimulus, remain hyper-stimulative. 

If that is the case, the Fed may suddenly find that it is far behind the curve rather than ahead of it as asset markets experience a melt-up rather than a melt-down.
What all of this means for the US dollar is debatable. Strong dollar proponents can point to the Fed’s recent rate hike talk shifting interest rate spreads in favour of the US dollar when we compare the short US rates with the rates of most other major currencies. After all, short rates are going any time soon from their negative levels in Japan and Europe, and countries like Australia and New Zealand are in a rate cutting cycle to absorb the damage from commodity price drops and worries over a slowing China.
Meanwhile, the dollar doubters certainly have a point when they point to still very low US rates and still negative real rates (when inflation is higher than yields on risk-free assets like US treasuries). 

For the US dollar to find more thorough fundamental support in a rising interest rate environment, the Fed may have to get even more hawkish still and US longer rates may need to rise as well – and more quickly than inflation is rising.

— Edited by Michael McKenna

John J Hardy is head of FX strategy at Saxo Bank


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