ETF Securities Research Blog

From the horse’s mouth: Fed rate hike likely to prompt further USD weakness

The market has been fully pricing in a rate hike from the Federal Open Markets Committee (FOMC) for over a month – since mid-May, the US Dollar (USD) has fallen nearly 3%. Recent Fed speakers prior to the ‘blackout’ indicate that the view is relatively pragmatic and balanced. However, the USD could still weaken further even if the Fed follows through on market expectations for a rate rise

Will they or wont they?

Fed commentary suggests that a continued gradual tightening of monetary policy is warranted. A rate hike would put the Fed funds rate at around the neutral rate, which is ‘in the vicinity of 1 percent’ according to Fed Chair Yellen. Fed vice-chair Fischer noted in mid-April that ‘a gradual and ongoing removal of [policy] accommodation seems likely to…maximize the prospects of a continued expansion in the U.S. economy’. Such an argument is based on the presumption that the healthy US economy feeds a stronger global economy. Another Fed voting Governor, Powell echoed Fischer’s sentiment in early June: ‘the healthy state of our economy and favourable outlook suggest that the FOMC should continue the process of normalizing monetary policy.’

Nonetheless, Governor Powell argues for the need for policymakers to be patient as ‘inflation has been below target for five years and has moved up only slowly toward 2 percent,…,especially if that progress slows or stalls.’ And then there are the more hesitant voting members: Governor Brainard is concerned that ‘if the tension between the progress on employment and the lack of progress on inflation persists, it may lead me to reassess the expected path of the federal funds rate in the future, although it is premature to make that call today.’

Implications

The rate path and the ability to enact credible fiscal policy are the keys to the direction of the USD. Certainly, the market will be surprised if the Fed does not raise rates but a key concern is whether the Fed have a Trump risk premium built into its forecasts?

USD market positioning has dropped since the beginning of the year when the ‘long Dollar’ trade appeared extremely stretched. We expect that the lower level of positioning is one reason why the downside risk is becoming more limited for the USD. However, foreign investors with long USD exposures need to be mindful that a rate hike associated with a ‘dovish’ statement, particularly if it suggests policy paralysis from the US Administration will be met with further USD weakness. Such USD weakness will undermine the returns that US assets have generated.

long usd posns

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