USD: Change of tone for the US currency - Rabobank

Jane Foley, Research Analyst at Rabobank, notes that the driven by better than expected US data and a few hawkish comments from a Fed official, the USD has been the best performing G10 currency measured since the start of the week.

Key Quotes

“While the appearance of a Fed hawk is hardly a new phenomenon, the better tone in economic data has boosted the validity of these views. Recent release of the US September non-manufacturing ISM index surged to 57.1 reflecting strength across its new orders, employment and prices sub-indices. Earlier in the week the September manufacturing PMI had managed a moderately better than expected reading and August factory orders and durable goods numbers were also better than market forecasts.

This week the yield on the 2 year t-note has hit a four month high and this morning the market implied probability of a December Fed rate hike is standing at 62%. The firmer tone in yields is counter to the prevailing trend of the year. The release tomorrow of the US September Labour data has the capacity to make or break expectations about a December rate hike from the Fed and a strong set of figures can be expected to support yields and the USD further. That said, since it will be difficult to rock the view that the pace of Fed tightening will remain slow into next year, we would expect upside potential for the USD to be limited.

In addition to the hawkish commentary from Fed’s Lacker this week, Vice-Chair Fischer has also been on the wires. Fischer concerns pertain to the very low level of the natural rate of interest rate. It is clear that in a number of major economies the inflation-adjusted neutral interest rate which would support the economy at full potential without creating the risk of overheating is much lower than in previous cycles. While the Fed is currently indicating an expectation that it could hike rates twice next year, we see just one move as being more likely and see downside risks to this view.

The market has spent most of this year and last year paring back expectations regarding inflation in the US and thus revising down its expectations regarding the trajectory of Fed tightening. The depressive impact that this prolonged adjustment in expectations has had on the US yield curve has had a defining impact on world financial markets. Investors has been forced into higher yielding, riskier assets and the soggy tone of the USD which has also been a function of low US yields has made it difficult for other central bank to soften their currencies – a factor which has inhibited their transmission of monetary policy measures.

Since a December Fed rate hike is not fully priced into the market, it is reasonable to assume that further strong US data releases have the potential to draw more upside potential from the greenback between now and the end of the year. However, as long as the market retains a sceptical view on the pace of Fed rate hikes into 2017 and beyond we expect that upside potential for the greenback will be limited. As a consequence we currently see little reason to adjust our forecast that USDJPY is likely to be mostly contained with a 100 to 105 in the months ahead. While we expect EUR/USD to be bias lower, we are forecasting a move only to 1.11 on a 3 month view and to 1.09 by the middle of next year.

Theoretically the risk that the ECB could further extend its accommodative policy stance next year should bias EUR/USD lower. However, as demonstrated by market reactions this week to ECB tapering rumours, the ECB will have to manage its communication strategy carefully to avoid further taper tantrums which could send the EUR higher. In any case, the ECB has this year found it impossible to pressure EUR/USD lower in an environment of falling US yields. For now it is the US yield curve and not the ECB which has the greatest control over the EUR/USD exchange rate.”