Fed moving closer to first rate hike

Fed moving closer to first rate hike …. but stronger USD far from guaranteed

Unsurprisingly, with the Fed moving closer to its first rate hike since 2006 and the ECB set to announce more stimulus in December, many observers are stating that the only way for the USD is up. Perhaps they are right. However, more USD strength should not be taken for granted. Indeed, there are several reasons why we would remain cautious on expecting further USD appreciation.

1. 1. Most if not all is already priced in. For example, figure 1 illustrates that currency markets have already been widely anticipating the divergence between the Fed’s and ECB’s expected monetary policy path.
2. 2. The USD is already expensive versus the EUR. According to the purchasing power parity (PPP) standard, a long term valuation method, the USD is starting to look expensive (graph 2).
3. 3. Other elements also play a role. At +3% of GDP, the Eurozone’s current account balance is clearly positive, while the US registers a deficit of around 2.5%. Moreover, the Eurozone’s cyclical outlook for profits is improving while the US is facing headwinds in this respect.
4. 4. Historical evidence. Evidence from the tightening cycles that started in early 1994 and mid-2004 shows that the USD strengthened significantly in both cases before the first rate hike, but then weakened against its major trade partners in the immediate aftermath and remained below the level of the first hike in the following years.

· Admittedly, past performance does not guarantee future results. At the same time, however, it means that a stronger USD is far from certain when the Fed starts to tighten policy. The upshot is that, despite a looming first rate hike in the US, most of the appreciation now seems behind us and a stronger USD/EUR exchange rate should not be taken for granted.

Hans Bevers – Senior Economist – Petercam IAM