The Fed and dollar depreciation

So no surprises. A slightly more dovish Federal Open Market Committee stuck to the script of future monetary policy moves being data dependent.

Since the US central bank last week scaled back its 2015 GDP growth forecast to 1.8%-2%, the implication is that rate increases, even if they start in September, will be a gradual affair.

Investors liked what they heard as this suggests that Goldilocks lives, and a “not-too-hot, not-too-cold” scenario remains possible for the rest of the year—the S&P 500 rose 0.2%, 10-year treasury yields fell to 2.27% and the DXY dollar index drifted lower by - 0.9%. We think the market got it about right, and the dollar will continue to trend lower on a softish growth outlook.

The cut in the Fed’s 2015 growth forecast from an earlier 2.3-2.7% partly reflects the soft patch in 1Q15. But Janet Yellen was also clear in stating that netexports have been a big drag. We think this is largely due to the strong US dollar, which will remain a headache for US producers. It is clear that the rise in the dollar’s real effective exchange rate since 2011 is now causing real pain for the US tradable sector, especially manufacturing.

Even as the property market perks up with the onset of summer, there is little sign of any recovery for metal bashers. US industrial production for May fell by -0.2% MoM, so there is little chance of a 2014 repeat, when both manufacturing and services picked up steam in the second half after a slow start to the year.

Last week, our analyst Charles argued that his key indicators were offering an almost entirely neutral reading, but he tended toward a negative view, implying US dollar strength. Together with US economist Will Denyer, we tend to have a mildly more optimistic view, which suggests the DXY is unlikely to rally substantially. History, of course, tells us that a further dollar spike cannot be ruled out, but any gains will render the US even more uncompetitive, in turn forcing the Fed to keep policy loose.

In the absence of economic overheating, the chances of the Fed being pushed into accelerated rate hikes is low. For this reason the softer growth outlook suggests that the eventual rate hike trajectory will be more gentle than might reasonably have been assumed at the start of the year.

By contrast, the European economies are showing increased signs of reflation as corporate lending and crossborder credit flows continue to improve. As such, we think the pendulum in currency markets will swing back in favour of the euro. After all, the dollar rally, which started last year, was driven by a sharp divergence opening up between a growing US and deflating eurozone. With those dynamics having gone into reverse, currency markets are likely to adjust.

As for timing, the “dot plot” made by FOMC members indicates that a US rate hike will come sooner rather than later (we really have no insight as to which month). However, the experiences of the last four rate hike periods has been for the DXY to depreciate in the period following the lift-off in rates—we expect a re-run this time around.

The Yellen Fed has thus far managed to shape expectations without causing big shocks, and so the chance of a 2013-style “taper tantrum” experience, sparked by a sudden shift in communication, seems less likely.

So long as this pattern continues to hold, then both the fundamentals and the institutional proclivities of this Fed point to the dollar having likely topped out.