Two factors to determine USD’s fate

USD may continue to rise if Fed is that rates will be hiked 25-bps next week 

The first is whether the Federal Reserve signals a pause in its policy tightening, perhaps as soon as the May 3rd meeting, and the second is the outcome of the debt ceiling struggle between the Republicans in the US and the White House.

Our call for the Fed is that rates will be hiked 25-bps next week but the bank will not definitively signal a policy pause. We suspect, instead, that the Fed will emphasise the data dependency of future hikes and we still think it more likely that it will hike further to a peak of 5.5%. In theory at least such an outcome could lift rate-hike expectations, weigh on bond and stock prices and boost the dollar.

However, in practice we believe that this will not materially lift the dollar. This is because the peak is still near and a policy pause will come soon, even if it is not as early as the May meeting. We would only see the dollar rising strongly in response to US monetary policy if the Fed somehow suggested that rates could rise much further, to 6% and above, for instance, but this seems very unlikely for our view is that even if inflation proves incredibly stubborn the Fed would just delay rate cuts, rather than produce a much higher peak rate.

In short, we do believe that US monetary policy will ultimately help deliver a lower dollar and all a tighter-than-expected policy can do is delay the fall, not provoke a substantial and sustainable rally.

The debt ceiling issue could be the factor that produces more volatility although, here too, we do not see this materially altering the longer-term outlook for the dollar to slide to the 1.20-1.30 range against the euro with similar declines against other major currencies. In coming days Treasury Secretary Yellen should update us on the critical period in which the debt ceiling constraint will bite in such a way that it risks debt downgrades by rating agencies and even a default. This could be some time in June. The last time the US experienced such tension, and suffered a debt downgrade, was in the summer of 2011.

Although default was avoided the issue prompted a huge decline in asset prices, especially stocks, as shown in Figure 1. This chart also shows that the dollar was relatively unmoved through the summer of 2011 and later rallied, although we do have to bear in mind that the ongoing euro zone debt crisis at that time was weighing on the euro. The dollar’s relative stability that summer may owe something to the fact that currency traders were caught between the fact that negative US events, such as a debt downgrade, might be expected to weigh on the dollar but, at the same time, such ‘risk-off’ events can lift the greenback via its safe-asset status. Coming back to today, we may find that the same forces are in play and hence that’s why we are inclined to believe that the debt ceiling issue is not one that we should factor into our forecasts in a material way.

Next week’s Fed and ECB meetings will likely have a bearing on currencies and that could be true of the Bank of Japan’s meeting this Friday – if the Bank adjusts its yield curve control (YCC) policy. Most do not seem to think that this will happen but the currency market is taking no chances as one-week yen calls have risen sharply compared to yen puts.

Even though there has been some adjustment in option pricing it still seems very likely that if the BoJ were to surprisingly give 10-year JGBs the opportunity to rise above the current ceiling of 0.5%, the yen would surge. It did this last December when the BoJ lifted the ceiling from 0.25% to 0.5% and we dare say we’d see the same rally on any further easing of the YCC constraint.

New BoJ Governor Ueda chairs his first meeting and many may remember that his predecessor Kuroda entered with a bang when he first took the reigns over a decade ago. For our part, we are sceptical of a policy change this week, but anticipate a change in coming months – and a stronger yen as a result.