Has the U.S. dollar outdone its rally? If the bulk of the USD bull market starting in summer 2014 was based on heightened expectations of a Federal Reserve rate hike, then would an actual Fed hike signal the peak? The response of the U.S. dollar to each of the last three Fed tightening cycles (1994-1995, 1999-2000 and 2004-2006) varied, but we found a common theme (see “Tightening the dollar”).
1994-1995: As the Fed began raising rates in February 1994, the USD fell more than 10% in the ensuing six months before stabilizing toward the end of the year and subsequently dropping an additional 7%. One of the reasons for the dollar selloff (despite the easy monetary policy pursued by Germany and Japan) was the resulting bond market crash following Greenspan’s tightening, which eroded demand for the U.S. currency. The resulting 10% decline in U.S. equity indexes didn’t help the greenback either. Despite seven rate hikes in 1994, the USD lost 5% to 15% against all major currencies, with the exception of the Canadian dollar, up 6%. In 1995, the USD lost against all major currencies, save for the British pound, Japanese yen and Australian dollar.
1999-2000: The 1999-2000 tightening cycle was the most positive for the U.S. dollar due to several reasons: Interest rates took off from a higher level of 5.00%, compared to 3.00% in 1999 and 1.00% in 2006; the Clinton Administration’s “strong dollar” policy consisted of rhetoric backed by U.S.-bound global capital flows as the euro crashed during its first two years due to policy errors from the European Central Bank and U.S.-Eurozone interest and yield differentials remained firmly in favor of the United States. The “New Economy” espoused by Greenspan’s low-inflation-high-growth paradigm made the U.S. stock market the only game in town as U.S. technology stocks were the magnet for global capital and emerging markets suffered a breakdown.
2004-2006: The Fed’s 125-basis points in rate hikes in 2004 didn’t prevent the USD from having one of its worst years in recent history, falling against the 10 top-traded currencies. Already in a two-year bear market, the greenback went from bad to worse because of a swelling trade and budget deficit. A nascent global recovery, led by commodities and their currencies, was a major negative. The one exception was in 2005 as the dollar had a strong upward correction because of a temporary U.S. tax law encouraging U.S. multinationals to repatriate profits. But the rally fizzled in December 2005 as the dollar bear resumed, courtesy of a secular bull market in commodities and higher-yielding currencies.
The current dollar rally from last summer into early spring 2015 is typical of pre-Fed hike rallies. If the Fed does tighten this September will it end? Despite notable labor market gains, the inflation requirement remains in doubt. The 20% decline in oil since early May will further retard any recovery in price growth, which has prompted the Fed to drop its phrase in the FOMC statement that “energy prices have stabilized.”
It will be difficult for the Fed to raise rates this year if WTI crude oil remains below $48 per barrel. The October-March decline has already triggered a chain reaction of broadening cuts in capital and labor expenditure from big oil and iron ore producers. After a spring-time recovery in crude, the declines emerged anew.
Fed hawks will ignore inflation and focus on unemployment, payrolls and wages. They will add that the non-accelerating inflation rate of unemployment or the equilibrium level of unemployment is at 5.3% to 5.5%, matching the current unemployment rate of 5.3%.
Fed doves will focus on inflation remaining below its 2% target. Dissecting market and survey-based measures of inflation will become a popular sport.
If the Fed does raise rates, it will most likely be a one-and-done rate hike, owing to the deflationary pressures weighing down through commodities. The peak of the USD bull market is already behind us.