By William Watts
The U.S. dollar is coming of the boil after a consensus-defying first-quarter bounce now that investor expectations for the Federal Reserve to begin raising interest rates by the end of next year are waning, but prepare for currencies to remain sensitive to changes in rate expectations, one analyst warned Tuesday.
“At the beginning of April, markets priced a full 25 [basis point] Fed rate hike for end-2022. The repricing this month has removed around 10 bp of that and the USD (U.S. dollar) selloff has followed this,“ said Adam Cole, chief currency strategist at RBC Global Markets, in a note.
The ICE U.S. Dollar Index /zigman2/quotes/210598269/delayed DXY -0.08% , which tracks the currency against six major rivals, was up 0.2% Tuesday after trading at its lowest level since early March in morning trade. The index is down more than 2% for April after bouncing 3.7% in the first quarter.
The dollar’s first-quarter run-up and subsequent pullback is in line with an environment in which it feels like small shifts in rate expectations generate large moves in FX markets — an observation that’s backed up by data, Cole said. In fact, FX moves have been around three times bigger than “normal“ for given shifts in forward rates.
The analyst pointed to the chart below, which tracks the standard deviation of rates across the economies with the 10 most heavily traded currencies.
He noted that central bank policy rates, as measured by the blue line, are more tightly packed together than ever before as policy makers around the world loosened policy in response to the pandemic. But 2-year yields, as measured by the black line, are clearly beginning to diverge as investors start to price in rate hikes in some markets, particularly the U.S., Canada and Norway.
In the chart below, Cole illustrates dollar sensitivity to shifting rate expectations. It measures what’s known as the beta between changes in the DXY and changes in the DXY-weighted 2-year rates spread. Over the long run, beta has averaged 7, which means a 10 basis point move in the rate spread is typically associated with a 0.7% change in DXY. Recently, after the disruptions caused by the early phases of the pandemic, beta shot to historic highs near 20, he noted.
The chart also reflects a historical pattern that’s seen periods of strong rate convergence associated with rising sensitivity in the currency market to small changes in rate prospects, Cole noted, with beta last trading near current levels in the middle of the last decade.
All in all, it looks likely that markets are going to remain highly sensitive to small rate changes, he said. And in Cole’s case, that backs up a call for a stronger dollar.
Cole noted that RBC expects U.S. rate expectations to rebuild, carrying the dollar higher, “though one does not need to be as positive as our economics team,“ which has penciled in two rate hikes in 2022, “to be moderately positive“ on the dollar.