US Dollar soars on hawkish Federal Reserve

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19 December 2016

thomasdodds

We had been pounding the table for some time on the critical importance of the December ‘dot plot’ from the Federal Reserve, where every Committee member is asked to contribute his or her view on the most likely path of Federal Reserve interest rates over the next three years.

F
X markets last week fully validated our view. The actual interest rate hike from the Fed was a non-event, as it was fully expected. However, the ‘dot plot’ communicated to markets that the Fed expects to raise rates considerably faster than it did back in September. The US Dollar soared on the news, and it ended the week up against every single G10 currency. The biggest drop was recorded by the Yen, as the traditional relationship between the USD/JPY rate and US interest rates reestablish itself. The Euro is also now very close to our target for the end of 2016.

The news calendar is very light until January, and FX markets traditionally quiet down in the last half of December over the Christmas holidays. We do expect the US Dollar rally to continue into the first half of 2017, and break parity with the Euro not long after New Years. The basis of this view is that US interest rates still have some way to rise before they are in sync with the views of the Federal Reserve, while there is no chance of higher interest rates in Europe at least into 2018.

Major currencies in detail:

GBP

Sterling-positive news last week enabled the Pound to hold its own better than most other major currencies amid the strong US Dollar rally. The Bank of England again sounded a more hawkish note than markets had expected, and retail sales provided yet another upside economic surprise. Our view that the Bank of England’s next move in rates will be up, although not for quite some time, is fully validated and we think Sterling’s rally against the Euro still has legs.

EUR

The business confidence indices in Europe continue to recover and point to better growth in the months ahead. The combination of ultra-lax monetary policy from the ECB and currency depreciation will, in our view, continue to provide a much-needed tailwind for the economies of the Eurozone. However, for the next few months, currency moves will be driven by interest rate differentials, so this better economic backdrop is not quite enough for us to change our Euro-bearish view quite yet. Nonetheless, the better tone in the Eurozone economy over the past few months certainly has bears watching.

USD

As universally expected, the FOMC increased the overnight interest rate by 0.25% in a unanimous decision. It also validated our expectations for a hawkish turn in its expectations relative to the September meeting. The FOMC member projection according to the ‘dot plot’ is now for three hikes in 2017, versus just two in September. There were also modest upward revisions to growth and employment projections.

Figure 1: FOMC December ‘Dot Plot’

Last week’s FOMC meeting was undoubtedly bullish for the US Dollar. We note that market levels of short-term interest rates in the US are still considerably below the Federal Reserve’s own expectations. As these expectations correct upwards, the widening gulf in monetary policy in both sides of the Atlantic should weigh further on the Euro and we reaffirm our forecast for a break through parity in EUR/USD in the first quarter of 2017.