Fed Chair Janet Yellen gave investors a green light to buy U.S. dollars today but with approximately 2 weeks left until the end of the year, it may be smarter to wait. About 13B worth of EUR/USD options are expiring this week and year-end rebalancing could cause erratic movements in the U.S. dollar. I prefer selling euros closer to 1.10 and buying USD/JPY closer to 121. The dollar experienced strong gains this year and with the most important monetary policy event of 2015 behind us, many investors may be tempted to take profits before the end of the year. However the Fed made it very clear today that have not been discouraged by recent data and are optimistic about the outlook for the U.S. economy. In fact they even raised their 2016 GDP forecasts and lowered their jobless rate estimates. They are still looking to raise interest rates 4 times next year, which is more aggressive than most people anticipated. This was not a dovish hike and the positive tone of Yellen’s testimony suggests that they are not overly concerned about the negative impact of low oil prices and strong dollar on inflation. Dollar bulls were vindicated by today’s events and anyone who has moved to the sidelines may be thinking about reestablishing their long positions.
The only problem is that the long dollar trade is still very crowded. According to the most recent CFTC’s Commitment of Traders, only a handful of traders cut their short EUR/USD and long USD/JPY positions after the 5-cent spike in the euro and corresponding slide in the dollar. The market is still heavily long U.S. dollars against many major currencies and we would like to see some of these positions reduced before reestablishing our own exposure. The dollar is rich and we expect it to get richer but many dollar bulls are exhausted and if they take profit before year end that’s when we want to be buying.
For the first time in 9 years, the Federal Reserve raised interest rates by 25bp and instead of downplaying the move, Yellen spent the large part of her press conference expressing confidence in the U.S. economy and the ability of inflation to return to 2% once transitory factors fade. Not only was the FOMC statement and Yellen’s testimony less dovish than the market anticipated but none of the FOMC members voted against the hike and the dot plot forecast was unchanged which means policymakers are looking for 4 more rate hikes next year. Yellen spent a bit of time talking about slow wage growth, slack and low new home building but it seemed to be nothing more than a nod to the doves. Between their higher GDP forecast, lowered unemployment rate forecast, the dot plot, the unanimous decision to raise rates and Yellen’s testimony – this was the best-case scenario for dollar bulls.
Yesterday’s financial market response was also the Fed’s best-case scenario because the most important monetary policy event of the year proved to be a dud for market volatility. Investors around the world braced for big moves in the U.S. dollar but were sorely disappointed when the greenback traded within 100-pip ranges versus the euro and Japanese Yen post FOMC. This muted reaction to a historic change in monetary policy is exactly what the Federal Reserve likes to see and despite all of their critics, we see this as a credit to their proper management of market expectations. U.S. policymakers spent the larger part of this year preparing investors for a rate rise, then spent the last few months emphasizing a gradual policy path and fueling expectations for a dovish statement. This helped to strip away some of the dollar’s recent gains, inject some two way flow and allow for it to rise from a lower based when rates increased today.
Looking ahead, the most important takeaway from today’s meeting is that U.S. interest rates will rise further in the coming year. Yield spreads have widened in favor of the U.S. dollar and with the risks that Europe faces in 2016 (refugee crisis, slow growth, more terrorism, Russia standoff), talk of parity could return. Fed policy is still data dependent and we won’t have to think about another rate hike until March but between and now then, the premium offered by the U.S. should sustain the dollar’s gains.
The greenback ended the day higher versus all of the major currencies with exception of AUD and NZD. Australia and New Zealand are the only 2 major economies offering a higher yield than the U.S. and with gold prices ticking higher, both currencies avoided steeper losses. New Zealand also reported stronger GDP growth for the third quarter, cementing our view that the RBNZ is done easing.
USD/CAD climbed to a fresh 11 year high and now has 1.40 in sight. Aside from U.S. dollar strength, the more than 4% drop in oil prices today should fuel further gains for the pair.
Sterling is vulnerable to additional weakness. GBP/USD tested 1.50 today and if tomorrow’s retail sales report disappoints, it could test its 8 month lows. The latest reports from the U.K. were discouraging with jobless claims rising and average weekly earnings growth slowing. Although the unemployment rate declined, the other components of the labor market report had a more significant impact on the currency. The risk is to the downside for retail sales tomorrow with wages slowing and the BRC retail sales monitor reporting a drop in demand.
Lower highs and lower lows post FOMC are a signal that the EUR/USD is poised for further losses. The latest round of Eurozone data was mixed. Manufacturing activity in German and France accelerated but service sector activity slowed. The trade balance also missed expectations while CPI fell less than expected. The German IFO report is scheduled for release tomorrow and even if it is good, we don’t expect a significant rally in the euro.