Two weeks ago the USD broke below last year’s low – a significant price move that means the greenback has, in effect, given back almost half of the gains it accrued during the preceding two-year bull-run. In the face of such strong downward price momentum it’s always easy to conclude that the “trend is your friend” and to anticipate further price declines. However, as we all know global financial markets are never that simple; rather, they often appear to move in a manner that seeks to confound the most people.
For the US economy, the USD depreciation witnessed over the past several months has clearly been a positive development. It has contributed to an easing in US financial conditions, which has helped insulate the economy from some of the growth headwinds previously identified by the Fed. However, because of the zero-sum nature of exchange rates, an equivalent strengthening in the currencies of the US’s major trading partners has simultaneously occurred.
This has been particularly problematic for Japan and the Eurozone, two economies whose central banks have seen their efforts to inject additional monetary stimulus thwarted – to varying degrees – by the resultant currency appreciation. To make matters worse, the “failure” of the JPY and the EUR to weaken in tandem with the injection of fresh monetary stimulus has encouraged speculation that both institutions have reached their policy limits, further complicating their efforts. So, it is not just investors who are keenly focused on the likely future path for the USD but also central bankers in Tokyo and Frankfurt.
To assess the outlook for the greenback, it is of course necessary to understand the catalyst for its retracement. For us, and many others, the answer is straightforward: the shift in rhetoric from the Fed over recent months and a reining in of investor expectations as to the pace of policy normalisation from Chair Yellen and her colleagues on the FOMC. By their words and subsequent actions, Fed officials challenged the comfortable consensus that had evolved around the notion that the USD would be a significant beneficiary of robust foreign capital inflows given the Fed was the only G10 central bank raising interest rates.
In support of this being the catalyst consider the following chart, which plots US interest rate outlook sentiment (red line) versus the trade-weighted USD index (black line). The significant and sustained decline in sentiment apparently anticipated the reversal in the USD’s bull-run.
As the above chart also confirms, following the sharp decline, sentiment towards the US interest rate outlook has stabilised at relatively low levels. Even though lower readings have been observed in this indicator during the post-Great Recession period, such occasions have coincided with expectations that the Fed is set to deploy unorthodox monetary policy tools (QE or large-scale asset purchases). So, unless one considers the Fed is about to embark on QE4 – and there is no hint of such from the FOMC participants whose votes would be necessary for such a policy to be implemented – it is hard to envisage US interest rate expectations as providing additional downside impetus for the USDIf anything, the low level of sentiment suggests the balance of risks towards both US interest rates and, by extension, the USD is positively skewed, particularly in light of an evolving trend that we
If anything, the low level of sentiment suggests the balance of risks towards both US interest rates and, by extension, the USD is positively skewed, particularly in light of an evolving trend that we emphasised previously.
From the admittedly very low levels seen at the start of the year, US inflation outlook sentiment has rebounded sharply to stand close to its long-run average (see chart below). Combined with medium-to-longer term measures of break-even inflation – imperfect market-based measures of private sector inflation expectations – having also increased in recent months this may prove sufficient to tip the balance in favour of a June Fed rate hike.
Given a June rate hike is not an outcome investors are presently assigning much probability to (Fed funds futures imply a 13% chance of a 25bp increase), and given how important changes in US interest rate expectations have been as a driver of the USD exchange rate, a positive interest rate shock could easily provide sufficient impetus to reverse the greenback’s recent slide. This is especially so given that both sentiment and optimism towards the USD (orange and red line respectively) have fallen to levels last observed immediately prior to the start of the two-year USD bull-run (black line – see chart below), implying that a sustained USD rally would constitute a “pain trade” for many investors.