Article / 24 May 2016 at 10:00 GMT

Fed rhetoric boosts US dollar, critical risks loom

Head of FX Strategy / Saxo Bank
  • USD boosted by Fed policymakers' message that summer hike distinctly possible
  • Blast of Fed rhetoric last week appeared to be coordinated message
  • Recent scepticism about further Fed hikes stemmed from dovish March FOMC
  • Next hike looks like a done deal in June or July if the US data permit
  • Fed now must decide if US economy sufficiently robust for another couple of hikes
  • That decision comes against backdrop of  big uncertainty in bizarre US election
  • Fed is in tricky spot also as to effects of its actions on global economy
  • For now Fed is putting on blinders and declaring total dependency on US data

Trump and Sanders effigies at Mardi Gras
 Donald Trump and Bernie Sanders effigies at a North Carolina Mardi Gras parade in February 
capture the essence of a bizarre year in US politics. Photo: iStock

By John J Hardy

The US dollar got back on the rally track, prompted by a parade of US Federal Reserve speakers last week warning the market that it is too complacent on the prospects of Fed rate hikes in what appeared to be a coordinated message.

Two regional Fed presidents mentioned the prospects for two to three rate hikes by year-end whereas the market was having a hard time fully pricing in even a single rate hike. The most pointed rhetoric came from influential New York Fed president William Dudley, who clearly indicated the Fed preference for a “summer” hike if the data keep pointing to a US recovery. 

The market’s scepticism of further Fed rate hikes appeared thoroughly justified by the very dovish pivot in the Fed’s rhetoric at the March Federal Open Market Committee meeting. It was clear at the time that the Fed had been thoroughly spooked by the turmoil that marked the beginning of the year, in particular Chinese currency devaluation worries, combined with a steep dip in equity prices and a credit market suggesting accelerating woes in the junk bond market. Of course, it was the Fed’s own dovish pivot that helped engineer the recovery in risk appetite since then.

So now the question for markets is two-fold. First, is the US economy sufficiently robust to warrant another couple of Fed rate hikes, particularly if we look at the political calendar? The next hike, at least, looks like a done deal in June or July if the US data merely heads sideways or better. Second, will global markets be able to withstand the global tightening implications of a strong US dollar? Or do we simply risk a repeat of the late 2015 and early 2016 situation, in which a stronger USD punished emerging market currencies and stocks, aggravated the Chinese devaluation issue and nearly led to a global equity bear market at the February lows? 

One problem that can’t be lost on the Fed is the risk to the US economy from the most unusual presidential election cycle in modern memory. If we look across the pond to the UK's June 23 referendum on the future of Britain's EU membership, it is clear that the uncertainty around this event may have fed a notable weakening in UK economic momentum this year. In the US, could the US election offer a similar obstacle for business confidence? After all, some recent polls have shown the widely detested Republican frontrunner Donald Trump able to edge out an increasingly struggling and also widely disliked Democrat Hillary Clinton in November. 

And will Clinton even be the Democratic nominee? She remains the target of an FBI criminal investigation on the use of a personal e-mail server to conduct public business while she served as Secretary of State, and her hard-charging opponent Bernie Sanders may leverage his surging popularity to contest her nomination at the Democratic Party convention in July, particularly if we wins the June 7 California Democratic primary. A Trump victory versus a Sanders victory – that’s a widely diverging pair of outcomes US voters and businesses can grasp.

So the Fed is in a very tricky spot, not only when it looks ahead at the US political calendar, but also when it looks around the world at the potential effects of its actions on the global economy, as it is the central banker of the global reserve currency. For now it is putting on its blinders and declaring total dependency on incoming US data. A very interesting and likely volatile second half of the year awaits markets as we navigate these issues and as the US dollar likely continues to strengthen for now.

The New York Fed
 The Federal Reserve Bank of New York whose president, William Dudley, 
clearly signalled his preference for a summer rate hike. Photo: iStock

— Edited by John Acher

John J Hardy is head of FX strategy at Saxo Bank


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