BAML: There's only one way for the US dollar rally to get back on track

Photo by Massimo Bettiol/Getty Images

If there has been a common trend with the US Federal Reserve in recent years, it’s been that that it’s been far too optimistic on where interest rates are heading.

Time and again, FOMC members have been forced to revised down their expectations for both the pace and degree of monetary policy tightening they expect to deliver.

The September FOMC meeting was no exception, as shown in the chart below from Bank of America-Merrill Lynch.

It shows the median FOMC member forecast for the expected path for the Fed funds rate, looking at the evolution in committee member views over the course of 2016.

Like the years beforehand, it’s been nothing but one-way traffic. Lower. It’s little wonder why financial markets remain sceptical that the current forecasts, even after being lowered again, are still wildly optimistic.

As it almost always does following a FOMC meeting where forecasts for interest rates have been lowered, the US dollar has weakened as a result. Many are now asking themselves whether that move is a sign of things to come or just a short-term bout of profit-taking.

According to BAML’s global economics, rates and FX strategy team, comprising Michelle Meyer, Ian Gordon and Mark Cabana, while the downward revisions to the Fed funds rate won’t undermine the US dollar, it won’t exactly help it to rally significantly either.

“The dollar will remain supported with the Fed on course to hike in December, but the magnitude of moves will be hindered by the slower pace of hikes implied by the lowering of the 2017/18 dots in the SEP [summary of economic projections],” the trio wrote.

With the US dollar likely to be “hindered” by the downward revisions from the FOMC, they suggest that the only way it will be able to rally in the period ahead will be if US economic data starts to strengthen, helping not only to lift market expectations for a rate hike in December but also a far faster tightening schedule than what is currently being priced in.

“A necessary condition for the dollar to rally is a more consistent pickup in US data so the market can price a faster pace of hikes in 2017/18,” they wrote.

“Until then any rallies will seem shallow, particularly with the market already pricing a 60% [chance] of a hike [in December].”

You can bet that other major central banks will be hoping for some stronger US data, starting with September’s non-manufacturing PMI and non-farm payrolls reports that will arrive in two weeks time.

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