SGOV - The End Of The Hiking Cycle And The U.S. Dollar
2023-05-16 00:45:00 ET
Summary
- The potential end to Fed rate increases may not be enough to cause dollar depreciation in the medium term.
- With market participants now pricing the end of the Federal Reserve’s hiking cycle, some commentators have suggested that this is reason enough for the U.S. dollar to depreciate in the coming months.
- However, while this makes intuitive sense, the data are not as supportive.
By Paul Stewart
The potential end to Fed rate increases may not be enough to cause dollar depreciation in the medium term.
With market participants now pricing the end of the Federal Reserve’s hiking cycle, some commentators have suggested that this is reason enough for the U.S. dollar to depreciate in the coming months.
However, while this makes intuitive sense, the data are not as supportive. Looking at the Fed’s previous five tightening cycles over the past 30 years, although the average three-month return of the U.S. Dollar Index after the last hike was positive, over six months it was negative.
Breaking these cycles down by looking at instances where the dollar depreciated in the six months leading up to the last hike, and instances - as in the current case - where the two-year yield was below the fed funds rate, the outcome for the dollar has been mixed.
In other words, the data suggest that the end of a hiking cycle alone is not enough to cause the dollar to depreciate further over the medium term.
There’s more support for an argument that any depreciation that would result from the end of the hiking cycle has already occurred; and that the dollar, in relation to this theme, is fairly priced.
We can test this idea by saying that the sum of the monetary policy rate and the two-year implied forward will take into account both the current level of interest rates and their future expected path.
Since the end of 2022, while the Fed has continued to raise its policy rate, the hikes have been offset by declines in the two-year yield, except for a financial instability-induced spike in March. The peak in this combined rate also saw the peak in the dollar index.
Looking at the euro/dollar relationship as an example, if we take the differential of the sum of monetary policy rate and the two-year yield for both the euro and the dollar, the euro/U.S. dollar is accurately priced.
Although this does not mean that the dollar will not depreciate further from here, we would argue that the Fed's reaching the end of its hiking cycle is not reason enough for it to do so.
In fact, against the euro in particular, we believe the dollar is accurately priced for the outlook currently priced in interest rate markets. Future movements in the dollar as a result of interest rates are likely to occur because yield differentials deviate from their expected path, not just because the Fed’s hiking cycle has come to an end.
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The End Of The Hiking Cycle And The U.S. Dollar