US Dollar Outlook: The market is behind the FOMC curve

US Federal Reserve (Fed) raises rates for the first time in nearly ten years by 25bps, to 0.25-0.50%. The future path of rate hikes is now the most important element of US monetary policy and will be the key for US Dollar (USD) direction

The Fed finally raises rates
In a highly telegraphed move, the FOMC has increased rates for the first time in nine years by 0.25%. Over the past 5 tightening cycles, the Fed hiked rates 7 times in the first 12 months.

Investors appear to fear a ‘1994’ type scenario when the Fed’s tighter policy triggered a bond market collapse. We expect that a bond market collapse is unlikely: the Fed’s inflation fighting credibility has increased as inflation expectations have come down over the past 40 years, resulting in a lower starting point for the current rate tightening cycle. While the Fed may be able to raise rates more gradually given its better credibility, its rhetoric must be clear: with the US economy moving towards full employment, inflation expectations must be contained.
Pipeline inflation pressure should be the Fed’s focus. If the Fed is too slow in raising rates in 2016, inflation expectations will begin to gain momentum and the only cure will be a more
aggressive rate profile. Global inflation expectations are rising and there is evidence of inflationary pressure in the system.
Core and trimmed inflationary readings are around 1.7-2.0%, suggesting underlying price trends are not as benign as the headline indicates. Wage growth is already near 2.5%, which is likely to strengthen as the US jobs market tightens.

Joining the dots
The Fed’s new economic projections indicate that the median expectation is for four rate increases in 2016. If such policy prevails, the market will remain behind the curve.

Implications for the US Dollar
Currently the market is pricing two further rate rises for 2016. Recent weakness is expected to turn into strength for the USD in the near–term, but a peak is in sight. We expect the USD to strengthen, but at a slower pace in Q1 2016 as inflationary pressure sees real interest rate differentials narrow. We expect the turning point for the USD will occur when market pricing catches up to the Fed projections of rate hikes in 2016. After Q1, rising inflationary pressure alongside a flattening US yield curve will see the USD decline as growth in real yield differentials turns negative.

Martin Arnold – FX & Macro Strategist – ETF Securities (UK)