As we head into the last three months of the year, currency traders remain at pains in predicting the course of the U.S. dollar to year's end. With the uncertainty of U.S. elections adding to the lack of visibility regarding the sustainability of the U.S. economic recovery, and with the extent of monetary policy shifts in and outside the United States doubtful, there is a range of market scenarios, each of which commands considerable probability.
But the two issues surrounding the dollar, which are increasingly making the rounds in forex trading desks, are those of the Fed and foreign capital flows into the United States. While few doubt the direction of U.S. interest rates, there remains as much dissent over the extent of Fed tightening as on its impact on the dollar. We will explain the impact of past Fed rate hikes on the dollar in the hope of shedding light about the forex effect of the current tightening cycle. As for capital flows, the increased role of U.S. Treasuries as the major recipient of foreign capital is raising questions about the over-dependence on foreign creditors. It is these very creditors that shall stabilize the dollar from any renewed damage.
"Spurious relationship" (right) is a clear illustration of the lack of a direct relation between the U.S. dollar and interest rate tightening policies over the last three decades. Indeed, higher yields improve the appeal of U.S. fixed income securities for investors seeking the extra yield. As investors rush in U.S. securities, they drive up the value of the U.S. dollar. But as the chart shows, the tightening cycles of 1976-79 and 1994-95 failed to generate any dollar gains.
Between fall 1977 and fall 1978, the dollar fell more than 15% after U.S. Treasury Secretary Michael Blumenthal talked down the U.S. currency in the hope of pressuring Germany and Japan to stimulate their economies, while encouraging exports in the United States. The 7% drop in the dollar occurred despite that interest rates had more than tripled during that period. The Fed's tightening, which had started a year earlier, was insufficient in reversing or even slowing the dollar's rout, until fall 1978, when Germany and Japan assisted in mounting the biggest concerted intervention operation of the time.
Policy was again the culprit during the 1994-95 Fed tightening. The Clinton Administration's aggressive trade policy toward Japan, designed to open markets, nearly ignited a trade war. The policy's impact on the dollar was so stark to the extent that it was dubbed the "Clinton Debasement" of the dollar. When Treasury Secretary Lloyd Bentsen was asked if he wanted a weaker dollar, he said he wanted a "strong yen." Those statements sent the dollar in a speculative downward spiral, as forex traders believed the U.S. administration was conducting a policy of benign neglect toward its currency.
Another main reason for the dollar's 1994 declines were perceptions that the Fed might have been behind the curve. Non-farm payrolls averaged about 350,000 per month, inflation averaged at 2.6% (annual headline CPI) while the Fed's aggressive 50 basis point rate hikes and inter-meeting actions sent perceptions of a miscalculating central bank.
SO WHAT'S AHEAD?
It is possible that the Fed's current tightening campaign shall produce a falling dollar for the year. Aside from the geopolitical risks and earnings uncertainty, there are concerns that the U.S. economy has cooled at the early phase of Fed tightening, thereby possibly deterring the central bank from adding to the dollar's yield luster. The regular speeches by the various members of Board of Governors and presidents of the Fed district banks are sometimes as important as the FOMC meetings because they tend to signal the FOMC's emerging stance on topics such as inflation, the pace of recovery and jobs.
So far, the Fed's tightening has been …