“The USD rallied sharply in anticipation of the first Fed hike, and we believe the hiking cycle is fully priced in. Given we also think the ECB and BoJ have reached the limits of QE, we see USD weakness in 2016”.
That’s the non-consensus view from HSBC’s FX strategy team, led by David Bloom, who believe that the USD dollar rally will not only stall in 2016 but that there “are grounds to anticipate weakness”.
The premise of their call is based off three key factors: the US Federal Reserve’s rate tightening cycle will weaken the USD, not support it, that the ECB’s power to engineer further euro weakness is low and that the Bank of Japan is unlikely to expand its QE program further in the year ahead.
Here’s the reasoning behind each of their calls.
1) The Fed tightening cycle will see the USD weaken not strengthen. History shows the USD weakens once the Fed starts to hike rates. In addition, we believe the conversation about the pace of Fed hikes will retain a very dovish tone in 2016, mirroring the experience of other central banks which have tried to raise rates after the 2008/09 financial crisis.
2) The ECB’s power to engineer a weaker EUR is low. The ECB faces constraints on how much further it can expand QE, both in terms of the amount of bonds available to buy, and internal support for further monetary easing.
3) The BoJ is unlikely to expand QE further in 2016. Like the ECB, the BoJ’s QE programme is reaching its limit, and we believe the central bank will move to a rates-based policy framework in 2016. In any event, the pressure for additional easing is on the wane given the BoJ’s focus on the new (and higher) core inflation measure.
While all three will no doubt create debate among market participants, perhaps the most controversial call is that further rate hikes in the US will not support the US dollar.
Analysts at HSBC suggest that history, monetary policy divergence being already factored in, a likely scaling back of rate tightening expectations from FOMC officials and recent data weakness will keep the US dollar on the defensive in the year ahead.
As for the first reason – history – the chart below from HSBC certainly demonstrates that the US dollar has tended to underperform in the period following the first rate increase of a tightening cycle.
Over the past four tightening cycles the US dollar index has fallen every time in the three months following the first rate increase.
As for monetary policy divergence being supportive for the US dollar, they also disagree.
In 2015, we also saw that a divergence in monetary policy is not a sufficient reason for a persistent shift in an exchange rate. When, in March 2015, we argued the USD bull run was coming to an end, a key part of the reasoning was that a lot was already in the price in terms of monetary policy divergence. This remains the case today. The market is priced for additional hikes by the Fed in 2016. The market anticipates the BoJ and ECB will continue with their balance sheet expansion in 2016. To argue for USD strength on the basis of policy divergence requires new information which prompts expectations of accelerated Fed hikes or more aggressive policy easing elsewhere. We expect neither.
They also suggest that the US dollar will be pressured as Fed tightening forecasts are scaled back towards current market pricing, not the other way around.
This chart below reveals the evolution of the median FOMC Fed funds rate forecast from December 2014 to December 2015 compared to current market pricing.
Should FOMC forecasts continue to push lower, it will potentially undermine the dollar. HSBC believes that will be the case, predicting the Fed will tighten rates twice in 2016, half the number currently anticipated by the FOMC.
Recent underwhelming US economic data is also likely to undermine economic growth expectations, hence rate expectations in their opinion.
For most of 2015, the only talking point was when the Fed would hike. For the early part of 2016, the conversation will turn to the pace of those hikes. But disappointing numbers will no longer just alter expectations of the pace of hikes. They will open the door to the possibility of the tightening cycle ending early, or even being reversed. It will be a very different conversation from the one held in 2015, and one which will keep the USD on the defensive.
The view of HSBC differs vastly to most market participants, at least based off median forecasts for EUR/USD and USD/JPY – the two largest components within the US dollar index – in the year ahead.
According to data from Thomson Reuters, the year end median market forecast for EUR/USD is 1.03, down from its current level of 1.0892. That for USD/JPY is 125.00, also well above its current level of 117.40.