The Fed strikes back, but on the other hand - Nomura

Bilal Hafeez, Research Analyst at Nomura, notes that the recent Fed Chair Janet Yellen’s speech in San Francisco reminded markets that we are in the midst of a Fed tightening cycle.

Key Quotes

“However, there was nothing to indicate that the Fed was likely to do more than the two or so hikes the median Fed dots imply or that we expect for 2017. But larger events loom, namely Donald Trump’s inauguration as US President. This may mark the beginning of the implementation of a series of protectionist measures that could see the dollar fall.” 

“Leaving aside any Trump effect, it is also worth bearing in mind that although the Fed has only hiked twice, it has effectively been tightening policy since 2013, when it began its taper programme. This means that we have had a three-year tightening phase, albeit a very stop-start one. Over this period, USD/JPY has risen 10% and the trade-weighted dollar has risen 24%. This is much larger than the previous two major tightening phases.”

“The last one from June 2004 to June 2006 saw USD/JPY rise 6%, but the tradeweighted dollar fell 6%. The major one before that from February 1994 to February 1995 saw USD/JPY fall 8% and the trade-weighted dollar decline 6%.”

“Moreover, within the current tightening phase, there has been a pattern where the dollar has tended to rally into tightening action and stall or weaken thereafter. Some of this is caused by bond yields, and hence Fed expectations have been scaled back after the Fed’s action. Last year equity markets also corrected lower after the December 2015 hike which helped the yen. Then there is the issue of real yields, which have tended to rise into Fed tightening actions and fall afterwards. This could be particularly relevant in the current part of the Fed’s tightening efforts as inflationary pressures have been gathering. So if bond yields rise, but for the wrong reason (ie inflation and so real yields may not necessarily be rising), then bond yield support for the dollar may not be forthcoming. We therefore remain comfortable with our bearish dollar view (especially against the yen).”