Last year when Futures looked at the rebounding dollar we asked, “U.S. dollar: Real strength or on steroids?” It was an odd question because despite an impressive rally in 2005, the dollar rebounded less than 30% from the low of the bear market that began in 2001 (see “Doubting the dollar”). It appeared at the time that many people were over-hyping dollar strength given the low from which it came. While a 29.5% correction is a nice start, it doesn’t really constitute a bull market — true bull markets can have corrections of 50% without damaging the overall trend. So it is probably safe to say that the bearish trend started in 2001 is still in play. If that means the U.S. dollar was indeed on steroids, then the drug of choice had to be the steady stream of interest rate hikes by the Federal Reserve Board’s Open Market Committee.
But in August the juice was cut off when the Fed finally suspended its streak of 17-straight rate increases. The Fed’s long incremental tightening policy was justified by an economy growing at a pace of nearly 4% per year and a steady increase in inflation fueled by explosive energy prices. But now that the economy appears to be weakening, the Fed may be faced with a dilemma: fight inflation or support the economy.
Brian Dolan, director of research at Forex.com, a division of Gain Capital, is bearish on the dollar, expecting it to drop 5% to 6% by year’s end. “The reason is the 180 degree turnaround in terms of interest rate expectations,” Dolan says. “Also the growth picture is getting ready to take a 180 degree turnaround as well.”
Dolan says a month ago the market was still looking at a robust U.S. growth of 3% to 3.5% in the last two quarters of the year. “We got a real wake-up call with [the weaker than expected] second quarter GDP. We are undergoing phase one of this turnaround where interest rate expectations are being lowered, interest rate hikes are being taken off the table and that is what is underlying the current dollar [weakness]. The next phase is going to be the undermining of the growth outlook and that is going to see the dollar undergo the next phase of weakening,” Dolan says.
Interest rate outlook
Global interest rates reflect a potential problem for the dollar, as the Federal Reserve appears out of bullets and other central banks are just gearing up for tightening campaigns.The Bank of Japan and the European Central Bank (ECB) began raising rates well after the Fed kicked off its rate hikes in June 2004 and each has further tightening to go, according to CMC Markets. CMC notes the Bank of Japan and the ECB benchmark overnight rates are at 0.25% and 3.00% respectively, and expectations are for them to end the year at 0.50% and 3.50%.
CMC contends that the inflation and growth arguments support further moves by the two central banks. Japanese inflation has produced seven consecutive monthly readings above zero, while economic growth shows its longest post-war positive streak. In the Euro zone, inflation consistently stood above the ECB’s preferred 2.0% ceiling, while the key economic indicators have transitioned from recovery to expansion.
As long as markets expect further tightening from the Bank of Japan and the ECB following the Fed’s pause, there is no additional carry benefit, and the yen and euro will most likely improve against the dollar.
It’s not just the yen and euro, the Bank of England enacted a surprise rate increase in August and more could be on the way. Interest rates in Australia are already above U.S. rates and the Aussie economy continues to grow with inflation above 4%. Despite 175 basis points of tightening, leaving Australia with a six-year high of 6% for short-term interest rates, the Reserve Bank of Australia has not yet signaled a definitive pause. Because of plentiful natural resources, Australia and New Zealand continue to benefit from the higher commodity prices as does Canada.
While the Bank of Canada is the one other major central bank that has signaled the end of its tightening cycle, ongoing strength in oil prices along with the expected dovish turn by the Fed, should maintain the USD/CAD rate below 1.14, according to CMC.
The significance of the Fed ending rate increases while other central banks are still tightening is that the dollar loses positive carry (see “Short-term rates,” left). While the Fed left the door open for additional tightening following its August announcement, some analysts expect continued economic weakness to push the Fed to reverse course.
Dolan says the Fed may have gone too far by attributing a slow fourth quarter in 2005 to Hurricane Katrina. “What has happened is the market was distracted by Hurricane Katrina. The fourth quarter represented the change in overall trend, the first quarter was the anomaly and now we are starting see a return to that trend,” he says.
Dolan expects the USD/JPY to end the year between 1.08 to 1.10. “Certainly 1.05 is not out of reach,” he adds. He pegs the euro at 1.3100 to 1.3150 by the end of the year and the USD/GBP at 1.95 to 1.98.
Michael Cairns, trading manager for FX Solutions, is not quite as bearish. Cairns saw traders paring back their short dollar position going into the August Fed meeting. He says it is more important to hear what the Fed says than what it does, and the Fed has left the door open to further tightening. Cairns is not convinced the Fed is done. “If they pause, it is not the end of the cycle,” he says.
Other analysts note that if it is the end of the tightening cycle, the dollar is in trouble because higher rates appear to be the only thing supporting the dollar. Garrett Jones, partner at Stockmarket Cycles Management Inc., says the Fed is between a rock and a hard place. “The dollar needs a consistent injection of higher interest rates in order to motivate buyers, without [higher rates] it is difficult to make an argument to buy or hold dollars,” he says.
Bob Kozak, currency analyst for Alaron Trading, says central banks are lightening up their dollar exposure to avoid larger losses in case of a downturn. “If we don’t increase rates we won’t be able to attract new capital to buy our bonds and notes to support our deficit,” Kozak says.
While Cairns is not as bearish as some, he expects the dollar to be lower by the end of the year, though he thinks the 2004 low of 8048 is safe. “I don’t think it is time to start aggressively selling the dollar.”
However, Dolan sees a good chance the 11-year lows of 2004 could be taken out. “I can see us testing into the high 70s.” Another bearish factor on the dollar appears to be the return of a more normal yield curve. The dollar rallied as the yield curve inverted but the reverse could now be true (see “End of strong dollar?”).
CMC does not believe the risk of slower growth has surpassed the risk of inflation though and see’s the potential for a dollar correction if the Fed returns to its hawkish ways. “While the Fed hawks may have preceded their foreign counterparts to the end of the tightening road, renewed inflationary pressures in the second half of the year could give rise to fresh price alerts, which carry the potential for a bear trap in the U.S. dollar,” concludes CMC.