US Dollar drops sharply on doubts over 2016 Fed interest rate hikes
08/Feb/2016 • Currency Updates•
The US Dollar had a rough time last week. The combination of doubts over a Federal Reserve interest rate hike in March and the cleaning out of stale long Dollar positions were driving a significant sell-off in the Greenback against every other major currency save the Mexican Peso.
The all-important US employment report on Friday brought some relief for the Dollar, as unemployment dropped again and wage growth finally started to pick up as a reflection of labour market tightness. However, the Dollar was still down almost 1.4% in trade-weighted terms for the week.
Interest rate markets are now pricing in just a 10% probability of a March hike and barely one hike for the whole of 2016. In our view, this is a significant mispricing, given the continued health of the US labour market, which is still the main focus of Fed policymakers.
The recent rally in the Euro has taken many businesses by surprise, as most expected the downward trend against the Dollar to continue. We’ve seen a lot of European businesses taking advantage of this by further hedging their positions and buying Dollars.
Major currencies in detail:
The Bank of England continues to send dovish signals. At the February MPC meeting the sole dissenter for higher rates, Ian McCafferty, modified his vote and the decision to keep rates unchanged was unanimous. The committee also revised downwards its expectations for short-term growth.
However, it kept unchanged its expectation that inflation would exceed the 2% target by the end of the forecast horizon, in 2018. This is the reason we are still expecting a UK interest rate hike in late 2016, in frank disagreement with the market which does not foresee one until 2018.
A tight labour market will, in our view, compensate for the uncertainty over the Brexit referendum and keep UK growth above 2% in 2016.
The labour market in the Eurozone continues to post solid improvement. Unemployment dropped in December to 10.4%. Although still unacceptably high, this is the lowest level since late 2011. Solid job creation in Spain remains a standout among the major Eurozone economies, at a net 36,000 jobs.
However, in absolute terms, this still reflects a very large amount of slack in the economy. Deflationary pressures are unlikely to abate any time soon and, in fact, long-term market inflation expectations are already flirting with all-time lows.
We think that further easing measures are on the cards as early as the ECB’s March meeting, including cutting the repo rate further into negative territory and additional expansion to the QE programme.
Given this outlook, we think the Euro will find it very hard to remain above 1.10 against the US Dollar.
Market expectations of the future path of Fed hikes continues to be the main driver behind financial market moves worldwide.
Last week those expectations continued to be unwound, until we received the US employment report for January. While the headline looked somewhat disappointing, the details were very encouraging. Unemployment dropped to an eight-year low of 4.9%, breaking the psychological barrier of 5% that the Fed appears to consider full employment.
More critically, wages grew a huge 0.5% for the month and are now increasing at an annual rate of 2.5%. With headline inflation falling towards zero, this means solid wage gains for US workers for the first time since the financial crisis.
The Fed has made it clear that it will react to market volatility only in so far as it filters through to US domestic conditions. The labour report is evidence that the US economy is so far relatively unaffected by market gyrations.
Interest rate markets are barely pricing one US hike for the whole of 2016 – this strikes us as a serious mispricing and, as it corrects, we should see the US Dollar resume its upward path.
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