Will USD fluctuate ahead of Fed’s tightening cycle?

The period of negotiating the start of the Fed’s tightening cycle could keep the dollar firm.

In the recent ECB meeting, members noted that the euro/dollar has tended to be more closely correlated with movements in short-term rate differentials than long-term yields. Their conclusion was that the market was focused more on speculation about US monetary policy than the longer-term returns available along the yield curve. However, Mr. Steve Barrow, Head of Standard Bank G10 Strategy doesn’t disagree with this – and it is one reason why he doubted that dollar strength would endure even as the Fed moves towards higher rates.

A rolling 3-mth correlation of short-term (OIS) rate differentials and euro/dollar is currently well above the correlation between 10-year yield differentials and the exchange rate. This might not be too surprising, especially as we are now at the point where monetary policy is about to change in the US as the Fed considers tapering its bond purchases. This makes the market (both short-term US rates and the dollar) particularly sensitive to information such as Fed speeches that shed light on the policy outlook. At other times, when the policy is quiescent, we might expect less sensitivity to policymaker comments and alike.

During these periods it might be the case that longer-term bond yields are a bigger influence on the greenback than short rates. It might seem a bit picky to try to make these distinctions between short and long-term differentials but it is important for a number of reasons. The first is that responsiveness to long rates seemingly reflects the expected pick-up that investors can receive from holding a higher-yielding currency. Sensitivity to short rates does not so much reflect expected returns as the more psychological effects that result from policy rate changes. For instance, an unexpected Fed rate hike would tend to lift the dollar because it would damage risk assets and lift ‘safe’ currencies such as the dollar. Of course, there could also be a yield effect as well if US long-term yields were to rise compared to others but, in this instance, the short-rate effect would dominate. Secondly, longer-term rates include other elements, such as term premium, and sometimes these can dominate the expected path of short rates, producing movements in yields that run counter to the direction of policy.

While the Fed is in this process of lining up policy tightening, the dollar will remain sensitive to events and that may well keep the dollar firm. But once the market is done with this, as Fed policy starts to change, and a ‘sell the fact’ mentality creeps in, we might expect longer-term rates to become more dominant as a determinant of the currency. But the problem here is that US short rates are only seen rising very moderately, up to less than one percent by the end of 2023. That still represents a one-percentage-point rise relative to the – very static – expectations for short-term rates in the eurozone, but is it enough to get excited about the upside for the dollar against the euro?

Euro/dollar has never really been a currency that’s been dominated by carry-trade considerations and, arguably even less so since the financial crisis when rate differentials have tended to narrow considerably. Yes, there might be sensitivity to front-end rates when the policy is about to change, but we would not argue that it is particularly strong at other times. In short, there’s not really enough to be gained from holding longer-term US bonds and shorting EGBs. “Another important point is that there’s far more scope for outsized gains in equity market positions, but these actually augur for euro strength, not weakness because US equities appear to many, ourselves included, to be quite expensive compared to their European counterparts. What’s more, as equity positions are less likely to be currency hedged, there is greater scope for flows to impact the euro/dollar. In sum, we think there are reasons why the period of negotiating the start of the Fed’s tightening cycle could keep the dollar firm for now, but we don’t see this strength persisting into the longer-term”, Mr. Steve Barrow stressed.