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 Tuesday 10 October 2017

US dollar - correcting or recovering?

 

 

If that’s the case and investors start to price this in then the dollar should resume its decline.

The US dollar has put in a respectable recovery over the last four weeks. This has seen the Dollar Index rally around 3.5% from the 34-month low that it hit early in the second week of September. Unsurprisingly, given the heavy weighting of the euro in the Dollar Index, the EURUSD fell 3.5% over the same period. This turnaround in the dollar’s fortunes represents the biggest percentage gain since the greenback began its near-relentless decline at the beginning of this year. At the start of January the dollar hit a fourteen-year high against the euro. But it then fell steadily and by early September the Dollar Index had lost 12.5% while the EURUSD had risen by close to 17%.

This recent improvement in the dollar’s fortunes has come about for a few reasons. Firstly, it was looking oversold technically and overdue some profit-taking. Secondly, investors seem less sure that the European Central Bank (ECB) will taper its bond purchase programme significantly next year. But on top of this the market has become convinced that the Fed will raise rates in December. This stems from the Fed’s last meeting on 20th September. This was when the FOMC released its latest Summary of Economic Projections which showed the FOMC’s “dot plot” predictions coalescing around the probability of a 25 basis point rate hike at the December meeting. In addition, the consensus view amongst members of the FOMC is that there will be a further 75 basis points-worth of tightening in 2018. So the overall takeaway is that last month’s Fed meeting was more hawkish than anticipated. This is despite the fact that a number of Fed members reduced their rate hike projections when compared to June’s “dot plot” and that the FOMC also reduced their long-term fed funds target to 2.8% from 3.0%. In fact, Fed Chair Janet Yellen’s subsequent speech and indeed her speech in Cleveland less than a week later also sounded more dovish than hawkish. Yet the CME’s FedWatch Tool which uses the “real money” fed funds futures market to calculate investors’ predictions for interest rates, now assigns an 87% probability of a 25 basis point rate hike in December - up from around 30% a month ago.

But could it be that the market has been wrong-footed? After all, inflation (as calculated by the Fed’s preferred measure, Core PCE) has fallen sharply over the course of this year. August Core PCE (the latest release) rose just 1.3% from the year before. Not only was this well below the Fed’s 2% target, but it continues to trend down from the +1.9% recorded in February this year. And while Friday’s Non-Farm Payroll report was distorted by hurricane disruption, the fact that it posted its first monthly decline in seven years must give the Fed food for thought. Certainly, if we see a continuation of tepid inflation and indifferent US economic data then the Fed could easily decide to hold off from raising rates again this year. If that’s the case and investors start to price this in then the dollar should resume its decline. This move would be exacerbated if the ECB signalled that it was prepared to start tapering its monthly bond purchase programme.

As we can see from the daily chart of the EURUSD, the dollar is at an inflexion point. The pair could be consolidating as investors book profits and cut their short-dollar exposure. This would suggest that the weak dollar trade isn’t over yet and that the EURUSD rally could soon resume. Alternatively, the euro may have topped out around 1.2000 and the chart could be in the process of completing a head-and-shoulders pattern. If so, then we could be on the cusp of a larger corrective rally in the dollar. What happens next depends to a great extent on how the Fed and the ECB respond to upcoming data releases and their appetite for tightening monetary policy after over eight years of stimulus. But ahead of that, tomorrow sees the release of minutes from last month’s meeting. If these confirm the market’s conviction that the Fed has a hawkish bias then the dollar should continue to rally. But if these reveal that a more dovish discussion took place, we should expect the dollar to resume its downward trend. 

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Posted by David Morrison

Tagged: Bulletin PM

Category: PM Bulletin


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