After Friday’s stellar US jobs report for October, the odds of the US interest rates moving higher in December have taken off. Markets now put the odds of the so-called “lift off” from the Fed at at 70%, a substantial increase on the even money call seen prior to the payrolls release.
Bond yields have risen, commodity prices fallen and stocks, well, they just don’t know what to make of it all. The one thing that we have all witnessed is some incredible US dollar strength. The US dollar index, largely influenced by its movements against the euro and Japanese yen, ripped higher on Friday, rallying more than 1% to 99.168, the highest level seen since mid-April.
It was a substantial move, and reflective of the growing belief that US rates will be increased for the first time since June 2006 in just over a month’s time.
However, despite Friday’s strong move, some believe the dollar rally hasn’t been anywhere near enough, suggesting that the move is likely just the start of a broader US dollar rally that is likely to evolve in the months ahead.
Goldman Sachs’ global macro research team, comprising Robin Brooks, George Cole and Michael Cahill, are certainly of this opinion. They’ve retained their view that the euro will fall to parity with the US dollar and beyond over the next 12 months, on the back of divergent monetary policy moves.
“A period of indecision for the dollar, from the March FOMC to recent ECB and Fed meetings, has ended,” the trio wrote in a research note released over the weekend.
“This week’s employment data have made December lift-off all but certain, validating the expectation of our US economics team, but markets – still suffering the after-effects of “The Interlude” – are hesitant to embrace dollar longs again.”
Brooks, Cole and Cahill suggest that there are two factors holding investors back from initiating fresh US dollar long positions: the perception that the Fed tightening may not be a positive influence on the US dollar, along with the belief that monetary policy tightening in the US may see the ECB hold off expanding monetary policy easing later in the year.
Given the substantial rally seen in the US dollar following the release of the Fed’s October monetary policy statement, something that indicated the FOMC are moving closer to a rate hike, the trio have little doubt the US dollar will benefit from higher interest rates.
“If markets are willing to reward a mere change in wording in this manner, we think there is little doubt that lift-off will be Dollar-positive. In short, we see plenty of scope for Dollar strength as the Fed normalizes monetary policy, in part because the amount of stimulus in recent years has been so large and unusual,” they note.
They also suggest that the notion ECB monetary policy is a byproduct of the Fed is incorrect, pointing to recent policy divergence from both central banks as a result of changing domestic economic circumstances.
“Both central banks look to be pursuing domestic objectives, which is of course what monetary policy should look like with freely floating exchange rates,” they state.
“We think the big challenge for the ECB is to get underlying inflation up towards its inflation target, which will necessitate both additional stimulus and, equally important, more stable Bund yields. Given the magnitude of this challenge and the reluctance of the market to re-embrace the Euro down theme, we still see plenty of scope for EUR/USD down.
Brooks, Cole and Cahill believe the EUR/USD is going to “parity and beyond”.
“It remains our expectation that EUR/USD will reach 1.05 ahead of the December ECB and parity by year-end,” they note.
Beyond that, they suggest the euro is likely to fall to just 0.95 over the next 12 months, representing a decline of 11.5% from its present level of 1.0738 if realised.