With market expectations firming around a likely interest rate hike by the United States Federal Reserve next month, it has also been commonly assumed that this will imply a rise in the US dollar. After all, higher US interest rates should make investing in the United States more attractive, which should attract investment capital and push up the greenback. Somewhat surprisingly, however, history suggests this is not always the case.
No clear link between $US trends and Fed tightening
As seen in the chart below, the performance of the US dollar in the past three Fed tightening cycles has been far from clear cut. In the (very aggressive) 1994 tightening cycle, for example, the US dollar declined quite notably during the whole period. In large, part of this reflected a flight out of US Treasuries by private international investors, who feared significant capital losses on their holdings. Indeed, US bond yields rose significantly throughout this period and US equities were also weak. Fed tightening effectively made it less attractive to invest in the United States.
The 2004 cycle was different again. The US dollar again weakened in the early months of Fed tightening (after a brief rally in the months prior to the rate hike), only to then rally in 2005 before slumping to new lows. The rally during 2005 has been explained by a change in US tax laws which encouraged corporations to repatriate profits held in offshore markets. The subsequent US dollar fall also coincided with a rise in European and Japanese official interest rates a year or so after the Fed’s first move.
Where are we today?
Against this backdrop, it begs the question what the US dollar might do in the coming year. The first (and perhaps surprising) answer is that the result is not clear cut. Investors should be cautious about making strong bets on US dollar performance simply based on the view that the Fed will raise interest rates over the coming year.
That said, history does provide some signposts. For starters, there does seem to be a risk of “buy the rumour, sell the fact” US dollar weakness in the early part of 2016 (at least against the Euro and Yen) given markets seem to have well anticipated the Fed move in light of recent US dollar strength.
Beyond this knee-jerk reaction, however, it’s likely Fed tightening will be closer to the gradual 1999 path than that of 1994 – suggesting foreign investors will be less likely to flee US bond and equity markets and place further downward pressure on the US dollar. What’s more, with the commodity boom over and technology stocks back in vogue, the coming year also favours reasonable US equity market performance which could also be US dollar supportive. And while US interest rates are not yet especially high compared to those of Japan and Europe, the gap should widen as it seems likely official rates in these economies will only follow those of the US with lag of at least a year or two.
In short, chances are that the US dollar performance in 2016 will be closer to that of the 1999 cycle compared to that of 1994 or 2004. This suggests retaining a constructive view of the US dollar after a possible knee-jerk period of weakness in the early months of next year. One risk to this scenario, however, is that investors find European and Japanese equities much more attractive due to still accommodative monetary policy in these markets. Another risk is that a sudden leap in US wage growth (due to low US unemployment) will result in a much more aggressive 1994 style period of Fed tightening.