Expecting the U.S. dollar to rise as the Federal Reserve hikes interest rates is a “canard,” that’s unlikely to materialize, said Alvin Tan, foreign exchange strategist at Societe Generale.
“The dollar-will-rise-as-Fed-hikes narrative is admittedly a nice story with a ring of logic to it, but it is a fairy tale,” Tan said in a note on Thursday. “If the narrative has indeed rung hollow in recent years, then there is little to support the proposition that Fed hikes will now surely drive the dollar higher, at least not against the euro, yen or pound.”
He noted that the dollar has failed to advance against the euro, yen or pound sterling despite the U.S. central bank beginning to hike interest rates in late 2015 and amid “ever-widening” monetary policy divergence and interest rate spreads in the greenback’s favor.
The euro/dollar is around 8 percent higher than the average spot rate in December 2015, and the dollar/yen is similarly lower, Tan noted, adding that this came even as both the European Central Bank and the Bank of Japan expanded their quantitative easing (QE) programs.
“If ever there was a case for monetary policy divergence to drive the U.S. dollar ever higher, this was it. Yet, the DXY Index is around 4 percent below the average December 2015 level,” he noted.
Five reasons the U.S. dollar may weaken
Societe Generale said it expects the dollar to weaken ahead, and Tan pointed to five factors that may drive the greenback lower:
- Tan said a “rich valuation” is one reason the dollar hasn’t been appreciating despite a tailwind from widening rate differentials and that should bring a weak gravitational effect to the currency. He noted the real trade-weighted dollar peaked in January of 2017 at levels higher than the previous cycle peak in February of 2002.
- In the near term, the U.S. business cycle is maturing, with the yield curve flattening, suggesting the market doesn’t expect inflation pressures in the U.S. are increasing, which may end up constraining the Fed’s moves, Tan said.
- The evolving Brexit situation and European economic data were set to influence the euro and sterling ends of U.S. dollar exchange rates, he noted, adding the European economic recovery was expected to gain strength ahead, which should boost the common currency.
- As a medium-term issue, the deteriorating U.S. fiscal and external balances could weigh on the greenback, Tan noted, pointing to Congressional Budget Office data forecasting the U.S. fiscal deficit to widen beyond what was seen in the 2000s, when the dollar trended lower.
- There’s also a “lurking risk” from the Trump administration, which has been more concerned by dollar strength than is usual, he said. “Given the Treasury Department’s existing authority to intervene in the foreign exchange market, one cannot rule out more forceful measures from the Trump administration in the event of an extension of the dollar rally,” Tan added.