Fed efforts to temper volatility could stumble the greenback
Fundamental talking points of the US dollar:
- US growth still leads the developed world
- The Fed’s schedule and the market’s patience
- Always the possibility of a crisis
The US dollar had everything lined up in its favor in the first half of 2021 and yet the currency struggled to gain ground. Some might argue that the base currency was simply playing the role of an unwanted safe haven as financial markets continued their post-pandemic ascent, but I don’t think that’s necessarily the case. The same appetite for yield in this speculative environment finds the greenback in a good position to attract capital to trend leaders like the S&P 500 pushing record or local yields bolstered by a rising 10-year Treasury as a benchmark. The fight arose out of the Federal Reserve’s diligent efforts to undermine surprise.
There seems to be a pretty clear path before the US central bank announces its intention to slowly withdraw from its extraordinary munificence by first unveiling plans for a cut. However, the timing of this announcement is up for debate and President Powell is making an incredible effort to squeeze all the surprise and impact from the official debut – the exact spark that leads to a significant market adjustment. So even if the United States enjoys competitive growth rates and market returns expectations, it can be difficult for the dollar to find serious traction… unless a serious downturn in risk strikes.
US growth still leads the developed world
In a world where the “efficient market hypothesis” sticks to its rudimentary interpretation, the dollar should outperform its major peers on the sole basis of its economic performance and outlook. Thanks to Markit’s June PMI figures (composite), GDP indicators showed that the United States had the fastest expansion clip of all of its major counterparts – including the Eurozone, the United Kingdom and the United States. Japan. Looking further ahead, the growth outlook favors the greenback further according to IMF forecasts, which have raised the pace from a projection of 5.1% in January to 6.4% in April. It is on the basis of significant fiscal and monetary injections and a desire to reopen the economy with vaccinations against the coronavirus. As promising as it sounds, the general reopening of the global economy is dampening the relative appeal that the dollar would otherwise have enjoyed. In a zero rate environment, capital gains matter more than returns.
Figure 1: IMF global growth projections from the World Economic Outlook Report (April 2021)
Source: April WEO IMF table
The Fed’s schedule and the market’s patience
The critical consideration on my radar – and I’m sure many other market players – for the third quarter is the timing of the Fed’s plans to reverse its monetary policy largesse. The group’s favorite inflation indicator hit its fastest annual growth rate in three decades with its May update. When announcing monetary policy in June, the central bank tried to avoid admitting that it would soon begin its tapering, but the rate forecast component of its Summary of Economic Projections (SEP) strongly brought forward the schedule of increases. The steering committee now expects two rate hikes by the end of 2023, although there is debate over whether a decision will take place in 2022.
On the other hand, the market seems to believe that a hike will indeed occur by the end of next year, referring to the implicit rates of Fed Funds futures. It may seem like a long way off, but the markets are looking to the future and there will be some adjustments that will precede the “take off”. An FOMC survey showed people expect the timeline to be: the reduction begins; followed by stopping asset purchases three quarters later; followed by the first rate hike three quarters later. This suggests that the announcement of these plans will come in the first few months of the third quarter. There is a FOMC decision on July 28 and the Jackson Hole Symposium will be held August 26-28. I don’t think the market has fully embraced this change, but the uncertainty surrounding this development could make trading conditions difficult before it becomes clear.
Chart 2: Dollar DXY index and implied change in federal funds in December 2022 (daily)
Source: TradingView; Prepared by John Kicklighter
Always the possibility of a crisis
Finally, it is important to consider the link of the greenback to risk trends going forward. In extreme risk aversion conditions, it quickly takes on the dress of a last resort safe haven. However, the threat of a full-scale financial collapse is a low probability, even with fears of excessive leverage throughout the financial system. In more moderate periods of risk on and off, the influence of sentiment tends to wane significantly. This may seem to contradict a chart that shows the dollar against a sentiment torchbearer like the S&P 500, but the correlation does not imply motivation. If risk appetite continues to climb at a measured pace over the next quarter, I don’t think that would drive the currency into a total collapse. Nonetheless, the search for returns for excess funds that are injected into the American system would still favor targets like emerging markets or even larger counterparties that have started to slowly strengthen their monetary policy, like the Bank of Canada or the Central Bank. from Canada. Mexico.
Graph of the DXY dollar index overlaid with the S&P 500 and the 60-day correlation (daily)
Source: TradingView; Prepared by John Kicklighter
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