Another year of US dollar dominance ahead as the Fed lifts rates

MOST currencies will struggle to make any gains against the United States dollar in coming months, as monetary tightening expected from the Federal Reserve (Fed) will provide the greenback with enough impetus to extend its dominance well into 2022, analysts says.

Nearly two-thirds of 49 foreign exchange strategists polled by Reuters between Jan 4-6 said interest rate differentials would dictate sentiment in major foreign exchange (FX) markets in the near term, with only two concerned about new coronavirus variants.

The vast majority of analysts polled said volatility in FX markets would increase over the coming three months, with well above 80% saying so for both majors and emerging market (EM) currencies.

In the meantime the Fed, now expected by traders to raise interest rates in March and begin reducing its asset holdings soon afterward, will provide the dollar with an edge over other major currencies.

Financial markets are now pricing in at least three US rate hikes this year.

"There's been a lot of US dollar strength of late, mainly driven by the widening interest rate differentials and inflation dynamics in the US relative to other major markets like Japan and Europe," said Kerry Craig, global market strategist at JP Morgan Asset Management.

"The fact the Fed is becoming much more hawkish and reacting to that by tapering much sooner than forecast a few months ago… (and soon) start raising rates should support the dollar over the first part of the year," he said.

Median forecasts lined up with that view as analysts do not expect most major and emerging currencies to make any significant headway against the greenback during that period.

While the dollar's dominance is nearly universal, as in previous Fed tightening cycles, emerging market currencies are likely to feel it the most.

"The macro backdrop looks challenging for emerging market assets," said Kamakshya Trivedi, co-head of global FX, rates and EM strategy at Goldman Sachs.

"Growth is slowing from peak rates as the reopening boost fades across the world, monetary policy tightening is under way, China has shifted to a lower gear of growth, and some all-too-familiar old-school EM issues like inflation, fiscal overreach and political instability are back on the table."

Among the emerging currencies polled on, the tightly-controlled Chinese yuan was predicted to depreciate nearly 2% to 6.5 per US dollar in a year. The Philippine peso, Malaysian ringgit and Indian rupee were also expected to weaken about 1% or at best cling to a range.

Turkey's battered lira was forecast to drop another 14% this year after plunging 44% in 2021, its worst year since President Tayyip Erdogan's AK Party came to power in 2002 and making it by far the worst performer in emerging markets.

South Africa's rand, another high-yielder but among the worst-performing emerging market currencies in 2021, is set to remain range bound in the next six months but fall 0.4% to 15.78 per US dollar in a year.

Most major currencies were also not expected to recoup their 2021 losses over the next 12 months.

The euro, which lost nearly 7% last year was forecast to gain a little under 1.5% by end 2022. Among major safe-haven currencies, the Japanese yen was expected to trade around current levels and the Swiss franc to drop around 3% in a year.

While the general direction of travel seems to be for the dollar to strengthen across the board as there is more clarity on Fed policy, analysts say plenty of risks remain.

"Given the uncertainty around how economies will evolve and how policymakers will respond, we are more confident in our view that currency volatility will be relatively high," said Jonas Goltermann, senior markets economist at Capital Economics.

Alarmed by the persistence of uncomfortably high inflation, even the most dovish of US central bankers now agree that they will need to tighten policy this year; the debate is no longer about whether, but how quickly.

St. Louis Fed president James Bullard on Thursday said the Fed could raise interest rates as soon as March and is now in a "good position" to take even more aggressive steps against inflation, as needed.

San Francisco Fed president Mary Daly, long a dovish counterpoint to Bullard's hawkishness, reiterated at a separate event that she too expects interest rate increases this year, even as she warned that overly aggressive tightening could hurt the job market.

Two rate hikes

And speaking earlier this week, Minneapolis Fed president Neel Kashkari said he now expects two rate hikes this year, a reversal from his long-held view that the Fed should hold off on rate hikes until 2024.

Fed policymakers are now effectively in two groups: "those who want to tighten policy, and those who want to tighten policy even faster," wrote Bill Nelson, a former Fed economist who is now chief economist at the Bank Policy Institute.

While most Fed policymakers remain in the first group, he said, "such a distribution would result in upside but not downside risks to policy (barring major economic surprises, of course)."

It is a big shift from just a few months ago, when Fed policymakers could be roughly divided into three: those supporting faster tightening, those who embraced a slower approach, and a contingent against rate hikes for a year if not more.

But inflation is running at more than twice the Fed's target of 2% and there is waning conviction at the Fed that the millions of workers sidelined by Covid-19 will quickly return to the labor force or that supply-chain constraints pushing up on prices will ease soon.So the appetite for patience has given way to an eagerness to move that is at odds with the Fed's continued, if slowing, purchases of Treasuries and mortgage-backed securities whose purpose is to stimulate the economy.

Last month US central bankers agreed to end their asset purchases in March and laid the groundwork for what most of them see as at least three interest rate hikes this year.

Minutes of the meeting released on Wednesday showed that some Fed policymakers want to move even faster to tighten policy, including by shrinking the Fed's US$8 trillion (RM33.7 trillion) plus balance sheet.

Widespread inflation

On Thursday, Bullard said he and his colleagues had been surprised at how widespread inflation had become, and laid out the case for a more aggressive path to combat it.

"It makes sense to get going sooner rather than later so I think March would be a definite possibility based on data that we have today," Bullard told reporters after a talk at the CFA Society of St. Louis.

"This is not a situation where a particular price will go back to the pre-pandemic level and we won't have to worry about this. This is an issue where Fed policy will have to influence where inflation goes."He added that "credibility is more at risk today than at any time" in his 30 years at the Fed. The Fed, he said, "is in good position to take additional steps as necessary to control inflation, including allowing passive balance sheet runoff, increasing the policy rate, and adjusting the timing and pace of subsequent policy rate increases."

Speaking at an Irish central bank event, Daly for her part also said the Fed should raise interest rates this year, in the face of a "very strong" labor market and to rein in high inflation that acts as a "repressive tax."

Still, she said, the US central bank's approach ought to be "measured." — Reuters

With interest rates as low as they are – the Fed has kept its benchmark overnight interest rate pinned near zero since March of 2020 – "raising them a little bit is not the same as constraining the economy," she said.

Daly added that it is a "very different conversation" from reducing the balance sheet, as doing so would only come after the Fed has begun normalising interest rates. – Reuters