The dollar has done – as it so often does – the opposite of what was expected. Last December, the Fed raised its target for the federal funds rate and indicated that this time it was serious about tightening and that it wouldn’t flip-flop anymore. Two weeks later, the dollar, after surging much of 2016, turned around and headed south in defiance of the Fed.
On September 8 intraday, the dollar index (DXY), which tracks the dollar against a basket of currencies, hit the lowest point since December 2014. In a little over eight months, it had dropped 12% from its intraday peak on January 3. But that was it. Since September 8, it has bounced nearly 3%. The chart shows the weekly movements:
Since early September, the dollar has bounced against the euro, the yen, the Canadian dollar, the Mexican peso, and the Chinese yuan between 2% and 6%. Based on the dollar index, the dollar has now risen four weeks in a row, though this morning, it is taking a breather. September 8 also coincides with the recent peak in the gold price expressed in US dollars — seen another way, the dollar has since risen against gold.
So why the dollar’s bounce?
One theory, among many, is that currency exchange markets – after blowing off the newly hawkish Fed for months and expecting it to flip-flop any moment, as it had done relentlessly starting in 2014 – are considering the possibility that the Fed might not flip-flop this time.
One more rate hike in December is likely. The Fed indicated after its last meeting that three more rate hikes next year seem likely, which would bring the Fed’s target range for the federal funds rate to 2% to 2.25%, up from around 0% not long ago – “low” inflation, no problem.
But more importantly, in September the Fed announced the start-date of the QE unwind, after having announced the mechanics and amounts in June. The QE unwind has now commenced. And the members of the FOMC voted for it unanimously.
With the QE unwind, the Fed will gradually destroy the money it had created during the phases of QE. It had watered down the dollar during QE with this money creation, now it’s going to reverse the process.
Rate hikes impact short-term yields. The QE unwind is designed to raise yields of longer-dated securities. Rising yields would make dollar-denominated bonds more attractive for international buyers stuck with ultra-low yields in other currencies, and when the plow into dollar-denominated securities, they also create demand for the dollar – or so goes one of the theories.
At the same time, additional political risks are creeping into the euro scenario, with Spain trying to repress Catalonia’s drive for independence, and with a right-wing party in Germany surging out of nowhere a few years ago to become the third largest player in parliament, thus weakening Chancellor Merkel’s grip.
So the dollar index bounced, but it remains down over 9% from its intraday peak on January 3.
Betting against the dollar remains a favorite sport for hedge funds, at least as of October 3 when there were $17.4 billion in short positions against the dollar, according to data from the Commodity Futures Trading Commission, though that had edged down from the prior week, and positions might have changed more by now.
The weakening dollar over the first three quarters this year has helped corporate earnings of those companies with overseas exposure, which includes most of the S&P 500 companies. When the dollar weakens, their sales and profits in other currencies are translated into more dollars, which makes the results look better on paper. A strengthening dollar will do the opposite.
What everyone wants to know now is this: Was this bounce just a blip, or was it the beginning of a reversal with stamina to move “higher for longer,” as they might say in the new jargon. The one-way trade against the dollar for the first eight months of the year seems over, and now it gets complicated.
Other central banks have also started to walk back their monetary policies. The Bank of Canada has raised rates twice this year and will likely raise one more time. The Bank of England has indicated that it might raise its rate, likely to happen in November. The ECB, which has already reduced its QE by €20 billion earlier this year, may announce more backpedaling after its meeting on October 26. The Fed leads, other central banks follow.
But next year is a wild card. Fed Chair Janet Yellen’s term expires in February, and President Trump has not yet announced whether he’d reappoint her or whom he’d appoint to replace her. There are three more vacant slots on the seven-member Board of Governors, and no one knows whom Trump will appoint to fill them. This new Fed that emerges next year, however, could be off the chart. Read… The Fed will be a New Creature Soon, and No One Knows What It’ll Look Like