U.S. Dollar Outlook Improving

Wall Street Journal – U.S. Dollar Rises Before Fed Rate Decision
Investors watch whether the central bank plans to accelerate its pace of rate increases this year
Most market participants expect the Fed to raise rates Wednesday. Investors also will be trying to determine whether the central bank plans to accelerate the pace of its rate increases this year. Expectations of higher rates tend to make the dollar more attractive to yield-seeking investors. Robust consumer-price data reported Tuesday argues for the Fed to signal an increasing risk of two more rate increases this year, analysts at Commonwealth Foreign Exchange wrote in a note to clients. “Such a scenario would likely keep the dollar broadly supported,” the note said.
Wall Street Journal – Powell Weighs Taking Questions After Every Fed Meeting
Investors have come to expect little policy action from the Fed at meetings without a press conference
Federal Reserve Chairman Jerome Powell is considering holding a press conference after every policy meeting rather than every other meeting, and his appearance Wednesday could help him decide whether it’s worth the trouble. At issue for the Fed: Since beginning press conferences in 2011, the central bank has fallen into the pattern of making major policy changes only at meetings followed by a news conference. The tactic has helped the Fed leader communicate its policy changes in more detail than its heavily scrutinized, jargon-filled postmeeting statement. But the practice has lulled markets into thinking the central bank won’t act between press conferences. “We’ve evolved to a place where the market only thinks we’ll move if there’s a press conference,” Atlanta Fed President Raphael Bostic said in an interview earlier this year. This is “a sign that what we’re doing right now isn’t working,” he said.

Summary

Markets are tuned in to see whether the Fed will diminish its reliance on forward guidance and deliver any clues about a potential fourth rate hike in 2018. The outlook for the U.S. dollar against developed market peers is mixed, but we see upside against the euro and yen.

Comment

Reports yesterday that Chairman Powell was considering press conferences after every FOMC meeting helped send the U.S. dollar higher. Markets read this as a sign that every meeting would become “live” as the Fed allows for greater uncertainty in the path of policy.

The charts below show signs of uncertainty creeping into expectations for interest rates and FX markets. Swaption volatility, one measure of fears related to rising rates, remains elevated though well off recent highs seen when U.S. Treasury yields appeared to break higher in late May. 3-month implied volatility for major U.S. dollar pairs has been rising for all but USDJPY.

Fair value estimates for the U.S. dollar against developed market majors point to a mixed outlook. We estimate fair values using 65-day changes based on Google search trends, changes in economic data and surprises, global fund flows, implied volatilities and performance of other asset classes. The charts below show the residuals, the difference between fair value and actual, in standard deviations, for major pairs.

We see room for the U.S. dollar to strengthen against the euro, pound, and yen. Fair values suggest downside risks against the Australian and Canadian dollars. Our fair value estimate for the U.S. dollar index (click for chart) is about 1.7% above actual.

Improving search traffic related to construction, real estate, furniture and consumer finance have brightened the skies for the U.S. dollar. Economic data misses in BRIC economies and improving performance in defensive sectors of global equities have driven more recent increases in fair value for the dollar index.

A strengthening U.S. dollar would present modest tailwinds for U.S. equities. The next chart shows 60-day correlations for S&P 500 industry groups against the U.S. dollar index. Autos & components, energy, and materials have shown the strongest (negative) relationship.

Conclusion

Much depends on how the Fed will shape expectations for the path of monetary policy over the next year. Its plans will be measured in the context of looming ECB decisions. For now, the outlook leans in favor of continued dollar strength, especially against the euro and yen.