Central Banks Other Than Fed May Dictate Direction Of U.S. Dollar
Editor's Note: View Kitco News' full 2018 outlook coverage
(Kitco News) - The fate of the U.S. dollar in 2018 may hinge not so much on what the Federal Reserve does with U.S. interest rates but what other central banks do.
The Fed is widely expected to continue tightening monetary policy, although at a gradual pace, in 2018. Normally, higher rates are supportive for a currency. But now that other parts of the global economy are coming back to life, other central banks may also either tighten monetary policy or signal rate hikes are on the way. If so, that could end up boosting those currencies against the U.S. dollar.
“Central banks are going to be the key in 2018,” said Pat O’Hare, chief market analyst with Briefing.com. “Everyone focuses on what the Federal Reserve is doing, but you can’t dismiss what might or might not happen with the ECB [European Central Bank] and Bank of Japan’s monetary policy as well.”
As of early Tuesday, the euro was around $1.18 and the British pound sterling around $1.34. The dollar was around 113 Japanese yen and C$1.27 against the Canadian dollar.
Despite the Federal Reserve’s three rate hikes in 2017, the U.S. dollar is seeing its worst yearly performance in 14 years. The U.S. dollar index, a measure of U.S. dollar strength against a basket of global currencies, is preparing to end the year down almost 9%, last trading at 93.26 points.
Among the dollar bears, TD Securities sees the euro rallying to $1.27 by the end of 2018 and the British pound sterling upticking to $1.35. Meanwhile, TDS sees the dollar falling to around 104 against the Japanese yen and C$1.25 against the Canadian dollar. CIBC sees the euro climbing to $1.25 by the end of 2018 and sterling to $1.38, while dollar/yen eases to 106 yen.
Among dollar bulls, Brown Brothers Harriman sees the euro falling to $1.08 by the end of 2018 and the British pound to $1.22. Meanwhile, BBH sees the dollar climbing to 118 yen and to C$1.36.
What The Dollar Bears Say…
“We’re U.S. dollar bears,” said Brittany Baumann, macro strategist with TD Securities. “This is based on a number of factors, with the first being a valuation standpoint. The U.S. dollar is still overvalued, based on the models we look at.”
Meanwhile, convergence in global economic growth should undercut the dollar, she said. Previously, the U.S. recovered more quickly, thus U.S. interest rates began rising earlier than in other developed nations.
“We think next year the Fed keeps hiking but still gradually and still not aggressively at this stage. But this is probably the first year that the Fed is not the only game in town,” Baumann said. “We do expect other central banks to start normalizing policies, either with rate hikes or just reducing QE [quantitative easing]. In addition to the Bank of Canada, we look for the other commodity-currency banks start hiking as well.”
Nick Exarhos, senior economist and director at CIB Capital Markets, also looks for dollar weakness, suggesting the shift in policy by some central banks is likely to be more dramatic than the Fed’s expected tightening.
“There is a more marked turn in policy from those other central banks than the U.S. Federal Reserve, which will be tightening rates as it has at a moderate pace,” Exarhos said.
TDS looks for the Bank of Canada to hike rates at least twice, plus calls for a hike by the Bank of England. The ECB is expected to signal an exit from QE, although this central bank won’t hike rates until 2019, said Baumann and Exarhos. However, economic data are likely to start underpinning the euro, they continued. Typically, strong data prompt markets to start factoring in rate hikes, thereby boosting a country’s currency.
Further, Baumann said, some movement in the forex market likely will be the result of capital reallocation. She said reserve managers are still heavily overweight in the greenback, meaning more capital may start flowing into the euro.
What The Dollar Bulls Say…
Brown Brothers Harriman is one of the banks that look for dollar gains, playing down the potential for meaningful tightening in most of the rest of the developed world.
“It’s still the higher U.S. rates story,” said Win Thin, global head of emerging markets with BBH. In a nutshell, BBH looks for the Federal Reserve to tighten two to three times, while other central banks stand pat or make limited moves to tighten policy.
“The Bank of England did hike once this year, but it was really just taking back the post-Brexit emergency cut,” Thin said. Otherwise, Thin said, Brexit risks remain and the economy is softening, meaning limited potential for U.K. rate hikes to underpin sterling.
Meanwhile, BBH looks for the Bank of Japan to maintain its program of quantitative easing. And whereas the European Central Bank is expected to end QE, no rate hikes are likely before 2018, Thin said.
“[ECB President Mario] Draghi said they wouldn’t start hiking until after QE is done,” Thin said. “If QE ends in say September, they are not going to turn around and tighten the next meeting. That’s why we think [rate hiking] is an early 2019 story.”
Briefing.com also sees a likelihood of a stronger U.S. dollar as interest rates rise some more, said Pat O’Hare, chief market analyst.
“If you’ve got interest rates driven up in the United States because economic activity is being driven up in the United States, then you should see a stronger dollar,” he said. “There should be a greater demand for U.S. assets in that type of environment.”