Why a Fed repeat of 2015 will not help the dollar

The market may expect a December rate rise, but the US currency is unlikely to benefit
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For all the drama and turmoil that has defined 2016, an air of predictability is starting to settle over this year.

Investors were unnerved by January’s oil price decline and fears over Chinese growth, they might have been thrown off course by June’s Brexit vote and this month’s failed coup in Turkey, and could yet have to contend with a Donald Trump victory in the US presidential election.

And yet, in one respect, 2016 is shaping up in much the way 2015 unfolded — a year of shifting communications from the Federal Reserve, bouts of weakness and strength in the US economy and record stock prices on Wall Street, culminating, according to some, in a likely rate rise in December.

“2016 looks very similar to last year,” says Nikolay Markov, economist at Pictet Asset Management. 

Ahead of this week’s meeting of Fed rate setters, the market has returned to pricing in the probability of a 2016 rate rise.

As economists at Goldman Sachs point out, the market has been on something of a “round trip” when it comes to rate expectations — warming to the idea in mid-May, getting cold feet in June with the shock of terrible jobs data and Brexit, before much better labour data in June and relative calm in financial markets winds up forecasts for a move in December.

This echoes last year’s pattern, played out at slightly different junctures in the calendar.

Taking its cue from the Fed’s own hawkishness, the market built up expectations of a rate rise at various points in 2015, until it was wrongfooted by the turmoil that followed China’s exchange rate policy shift in August.

“September was the ideal opportunity, then they kicked it into long grass,” Tim Graf, head of macro strategy Europe at State Street, says of last year. As the Fed’s December meeting loomed, the rise had become “so well telegraphed”.

A December 2016 rate rise now looks the settled view of the market, one that will be tested when the Fed reveals its latest assessment of the economy on Wednesday.

The market’s scenario is that September is too soon for a rate rise and November looks stymied by the US presidential election, leaving December once again as the default.

“Which means the dollar does a bit better going into year end,” says Mr Graf.

“We’ve weathered the big sell-off in risk assets, the Chinese slowdown and Brexit, which looks like a more localised phenomenon,” he says.

The wild card is the US election. “The market is definitely not priced for that,” he says. 

As they approached the end of 2015 in a state of near-exhaustion, the market and the Fed accepted a December rise could be digested without too much alarm. Is the same true this time around? Clues lie in the dollar, which is not exhibiting the same pattern of behaviour as 12 months ago.

US economic strength, Fed hawkishness and rate rise expectations last year pushed the dollar to a 12-year high. The index measuring the greenback against its peers was up 9.3 per cent over the course of 2015. So far in 2016, it has fallen 1.3 per cent.

“In the middle of last year, the dollar had completed a historic trend movement,” says Mr Graf. “Now, 12 months on and the dollar has done nothing. The dollar has really gone nowhere.”

The US economy, which tends to correlate with the dollar’s fluctuations, offers little by way of explanation. In some respects, the US economy has hardly changed.

Marc Chandler, of Brown Brothers Harriman, points to a likely repeat in the 2014-15 pattern of the US economy — a strong fourth quarter followed by a weak first quarter, then a recovery.

“All the data are coming up strong for the US economy,” Mr Chandler says. 

The reason why a December rate rise is more problematic than last year’s end-of-year increase lies in the Fed’s decision to realign its sights to take into account global factors.

It was a “Damascene moment”, says Mr Graf, with the Fed becoming more willing than in the past to take into account the significant impact the dollar moves have on global finance.

The difference in the Fed’s approach, says Mr Markov, is that, whereas price stability used to be the primary mandate of central banks, it has now been usurped by financial stability.

But it has meant the Fed has lost its ability to act pre-emptively, he believes — too hesitant in starting the rate rise cycle for fear of market volatility.

“They have put too much emphasis on financial stability,” Mr Markov says. “Even a small rate hike might have a strong negative impact on markets and the risk is it triggers a negative feedback loop that compresses consumption that would impair the recovery of the economy.”

Caution has governed the Fed all year, so however resilient the US economy, it must proceed cautiously if it wishes to shift policy towards rate normalisation — and that means keeping the dollar in check.

This is “a new normal for the Fed”, Mr Graf says. One consequence is that policy divergence with Europe and Japan will be only “of a very gradualist magnitude. The fruits of that were played out in 2014. In this cycle, it’s run most of its course”.

If the Fed does raise rates in December, 2016 will feel like déjà vu. Except that, for better or worse, Fed policy has fundamentally changed.

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