Hawkish Fed cures dollar’s schizophrenia

The dollar surged higher across the board on Wednesday as US Treasury yields hit fresh 2013 highs as the Fed failed to reassure investors after its FOMC meeting that the tapering of its quantitative easing (QE) programme and eventual monetary tightening would only be gradual.

The Fed now believes the downside risks to the US economic outlook and labour market have “diminished since the fall”, and that if gains in the labour market continue and economic data are broadly consistent with a pick-up in growth, then it will moderate the pace of its purchases later this year and end QE in the middle of next year.

That triggered some speculation that the Fed could begin tapering purchases as early as next month, and encouraged the market to bring forward the timing of the first US rate hike to the end of 2014.

The fact the dollar rose against EM and leading currencies is a telling shift for the FX market.

That is because, up until the Fed meeting, the dollar had been suffering from what Jens Nordvig, global head of FX research at Nomura, describes as an “unusual type of schizophrenia” since Ben Bernanke, Fed chairman, first floated the idea of tapering Fed asset purchases last month.

That saw the dollar gain ground against EM currencies, as well as the Australian dollar, but fall markedly against leading currencies such as the euro, yen, sterling and Swiss franc. Indeed, in the two weeks before the Fed meeting, the dollar fell 3.8% against the Fed’s G10 index, and was around 2% higher against its EM index.  

The reason for the dollar’s outperformance against EM currencies – and also the Australian dollar – has been the destruction caused to carry trades by the rise in volatility sparked by speculation of Fed tapering. Indeed, since Bernanke mentioned the prospect in testimony on May 22, as can be seen in the chart below, currency moves have been inversely correlated with one-month carry. 

Perhaps counter-intuitively, however, the rise in speculation of Fed tapering did not boost the dollar against G10 currencies. That is because the rise in rates, although initiated in the US, quickly became a global phenomenon. The sell-off in US treasuries and resultant rise in yields was thus unable to boost the dollar against G10 currencies, where FX moves continue to track interest rate differentials.

Indeed, Bernanke’s testimony marked the high for the year for the dollar index, which tracks the currency against a weighted basket consisting of the euro, yen, sterling, Swiss franc, Canadian dollar and Swedish krona.

The chart below shows implied interest rate differentials from Euribor futures and eurodollar futures. It shows that although it was the Fed that started talking in a more hawkish fashion, it is eurozone rates – implied short sterling rates as well – that have risen relative to US rates since late May. 

That could well change as a result of Wednesday’s Fed meeting since although the central bank still projects the first Fed hike in 2015, more members appear to think there will be more than one rate rise.

Before Wednesday, FOMC forecasts for the Fed funds rate at the end of 2015 were bunched around 0.5%. Now they show a wider dispersion, with the favoured forecast 1%.

With the Fed effectively raising its forward guidance on rates, the rise in implied rate differentials between the US and other G10 countries should go in reverse. That could spell the end of the dollar’s weakness against other leading currencies.