Fed policy may turn U.S. dollar outlook

May 23, 2018 10:59 AM

As any  Economics 101 student learns, the Federal Reserve is responsible for U.S. monetary policy, including setting the level of interest rates, and more recently, managing the central bank’s vast assets acquired through repeated iterations of Quantitative Easing (QE). 

In March, the central bank raised interest rates for the sixth time this cycle; both the Fed’s own projections and market expectations expect another two rate hikes this year, followed by another two or three increases in 2019. Meanwhile, the central bank has stopped reinvesting the proceeds from its asset holdings, starting the long process of decreasing its bloated balance sheet. At first glance, the Economics 101 student should conclude that the Fed’s classic tools of monetary policy may now start to become a headwind for economic growth for the first time in nearly a decade.

However, Economics 201 students learn that the Fed is also responsible for another critical aspect of U.S. economic growth: banking regulation. In October, Randal Quarles was confirmed by the Senate as the central bank’s first vice chairman for bank supervision. As you might expect from a former private equity executive, Quarles has prioritized finding ways to decrease regulations on the markets.

Quarles has proposed overhauling trading limits, streamlining capital rules and changing the Fed’s stress testing process. Notably, the Fed has been working closely with other banking regulators on a proposal that could allow banks to exclude certain assets from leverage ratio calculations, potentially allowing those banks to make more loans on the same amount of deposits. In addition, Quarles has set his eyes on revising the Volker Rule, which restricts a bank’s ability to trade with depositors’ funds, and clarifying the criteria for its regular bank stress tests. Each of these changes is intended to decrease bureaucracy and make the banking system more efficient.

Thus, while it is true that the Fed’s traditional monetary policy stance has changed from a tailwind for the U.S. economy to a neutral factor at best, the central bank’s regulatory actions have simultaneously become more supportive for growth by making it easier for banks to lend funds. Add in a fiscal policy boost from the Republicans’ recent tax cut, and the economics textbook suggests that the U.S. economy could be poised for strong growth during the next couple of years.

Strong domestic growth would benefit U.S. stocks, but it could also support the dollar by allowing the Federal Reserve to continue raising interest rates to beyond their equilibrium level. After a decade as one of the lower-yielding major currencies, the greenback’s benchmark interest rate is already at the same level as traditional carry currencies like the Australian and New Zealand dollars. Barring a surprise shock to growth, the Federal Reserve is expected to raise rates more aggressively than any of its major rivals in the years to come.

As of late March, the U.S. Dollar Index is trading near a three-year low (see “Dollar technicals”). The greenback has trended consistently lower since the start of 2017 as the luster of the Trump Trade has worn off and other central banks show signs of tightening. 

The 61.8% Fibonacci retracement of the 2014-2017 rally near 88 represents a critical support level. A break below that area would open the door for a continuation toward the mid-80s. Meanwhile, bulls are looking for the Dollar Index to rally back through previous support and the 50% retracement near 91.50 to signal a turnaround. The next resistance level would be the November 2017 high of 95.00. If we see that, it could be a sign that traders are finally moving from an Economics 101 perspective to Economics 201 view, waking up to the potential of a more dynamic banking sector supporting strength in the U.S. dollar.  

About the Author

Senior Technical Analyst for FaradayResearch. Matt has actively traded various financial instruments including stocks, options, and forex since 2005. Each day, he creates research reports focusing on technical analysis of the forex, equity, and commodity markets. In his research, he utilizes candlestick patterns, classic technical indicators, and Fibonacci analysis to predict market moves. Weller is a Chartered Market Technician (CMT) and a member of the Market Technicians Association.