Will USD slide despite FED tapering?

Even though the Fed is inching closer to a tapering of bond purchases, the FX market does not seem to have a great appetite to buy more U.S dollars.

The dollar continues to trade in pretty narrow ranges against most currencies. And even though the Fed is inching closer to a tapering of bond purchases, the FX market does not seem to have a great appetite to buy more dollars. Positioning data suggests that long positions are already high, at nearly USD22bn on the IMM, and this may be preventing the dollar from rising much further. 

What’s more, the Fed tends to have a recent history of producing what might be called “dovish tightenings” that don’t lift the dollar, and Mr. Steve Barrow, Head of Standard Bank G10 Strategy thinks that next weeks will fit that mould. What he means by this is that the Fed is likely to use the taper announcement to emphasise that there is a distinction between reducing bond purchases and starting rate hikes with the latter only likely to start some time after tapering has finished. The Fed is very aware of the global connotations of its policy actions and will work hard not to spook the market. 

Meanwhile, other major central banks don’t have these global responsibilities and hence, in the UK, for instance, the Bank of England has not shown a similar degree of caution to the Fed as its monetary message has turned much more hawkish recently, even to the point where rate hikes may start to occur before tapering has finished. With this in mind, it sems that the policy tightening of other central banks could have bigger reverberations for currencies than the Fed’s, which would fit Mr. Steve Barrow’s call for the dollar to slide over the longer term even though US rates rise will.

Even if US rates don’t rise at a much faster pace than elsewhere, dollar bulls will still point to a more dynamic economic recovery in the US as likely to lift the dollar. Indeed, the US economy has fallen less and recovered more than the euro zone. However, there are several points to make about this. 

The first is that the gap is likely to close with the release of both US and euro zone GDP this week. 

The second is that supply-chain difficulties are more likely to hold back the US recovery than the euro zone. 

The third is that vaccine resistance in the US remains higher than Europe and that could mean that pockets of weakness persist in the US for longer than we see across the euro zone. 

And finally, the US has spent in the region of 25% of its GDP on fiscal measures to cushion the economy against the pandemic. It is more than twice the euro zone average and, as this support drains away, so it could weaken the US economy relative to the euro zone, and indeed other countries as well given that the US has pushed the fiscal boat out so much more than anyone else. “The bottom line is that growth differentials might not produce the spur to dollar strength that many might be assuming and we are comfortable with our call that the dollar will slide to the 1.30-1.40 range against the euro over the next year, or two”, Mr. Steve Barrow said.

Sterling will be a big focus for the market, particularly on the policy front given the budget this week and the Bank of England’s meeting next week. A key issue on the budgetary front is how quickly and how aggressively the government seeks to claw back the huge spending undertaken during the pandemic where the furlough scheme alone cost upwards of GBP100bn, or more than twice the entire budget deficit for the fiscal year before Covid-19. In the wake of the global financial crisis of 2008 the UK government was accused of being too fiscally austere at a cost of a weak recovery. 

This time around, it seems as if the government is being a bit more cautious, that will bode well for sterling. The BoE could also aid the pound next week if it lifts base rates. However, Mr. Steve Barrow said that any rise would only be 15bps at this stage and he remains concerned that the market could see this as a panic move by a Bank that has fallen behind the inflation curve. Hence, sterling’s upside could be limit ed so that gains he expected over time to the 1.50- 1.60 range against the weaker dollar are not necessarily replicated against other currencies such as the euro.