Contrary to expectations, the US dollar rally after the Fed's first interest rate hike since 2006 has failed to materialize. Conventional wisdom held that an increase in interest rates would strengthen the dollar, especially as the other major central banks continued their stimulus programs.
But the dollar is not responding to the rate hike as expected. In fact, it has fallen since the rate hike, snapping a three-month rally. What could possibly be behind this?
The 2015 Dollar Rally
The two main drivers of the 2015 dollar rally were expectations of a US rate hike, and safe haven demand as economic activity in China and emerging market nations fell. Investors and speculators piled into the long dollar/short euro trade after the European Central Bank announced new stimulus measures. The liberalization of currency controls in China saw the yuan drop against the dollar, and expanding stimulus in Japan saw the yen weaken.
As central bank policies diverged and the US economy showed growth, the dollar continued to gain. On December 2, the greenback hit a 12-year high of 100.51 on the DXY dollar index.
Is The Dollar Rally Done?
However, the next day saw a sharp correction. The dollar's gains for the year dropped to 9%, while values for December were down 1.7%. The USD/EUR trade became over-bought, and the euro snapped back in December after the ECB didn't expand its stimulus measures as much as expected.
Another contributing factor was the "buy the rumor, sell the fact" that occurred the day of the Fed rate hike. Talk over the last few months that an interest rate increase had been "baked in" to the markets seemed to have been short of the mark. It was more like the markets had "over baked" the rate hike, leading some investors to getting burned. The pain for those long on the dollar began the morning before the Fed announcement.
What's Causing the December Drop in the Dollar?
A combination of year-end book balancing, profit-taking, and cautiousness ahead of the January FOMC meeting has sent the dollar lower.
Some of the long dollar trades have been running for quite a while, and the time has come to bank those profits. Fund managers especially will be taking profits to make the end of year statements look as good as possible. Other, diversified funds now need to rebalance their holdings. Since the dollar has risen so much, they have to reduce the amount of dollars they have.
Investors both big and small are also moving to the sidelines, waiting for some clarification from the Fed regarding the pace of rate hikes going forward. Some analysts are pointing to the dollar rally 's large gains for 2015, noting that a reversion to the mean after such big moves would result in a correction. This was almost certain to happen this month, as the main factor driving the rally (a rise in interest rates) has come and gone.
What's Ahead For the Dollar?
Unsurprisingly, the largest influence on the dollar in the first quarter of 2016 will be the Fed. While practically no one sees a chance of back-to-back rate hikes, March is definitely on the table. The four rotating voting positions on the Fed Open Market Committee, which sets rates, will be occupied by four monetary policy hawks. James Bullard, Esther George, Loretta Mester, and Eric Rosengren will replace Charles Evans, Jeffrey Lacker, Dennis Lockhart, and John C. Williams.
But even with this hawkish lineup, most market analysts expect only two rate hikes in 2016, compared to the four rate hikes planned by the Fed. This will likely lead to the dollar consolidating in the first quarter.
A factor in favor of a resumption of the dollar rally going forward will be El Niño. (Hey, everyone blames it, so why not us?) As New York City is looking at temperatures in the mid-60s for Christmas Day, expectations of unseasonably warm weather across much of the country is expected to cause a drop in heating bills. Cheaper gasoline will leave consumers with a bit more cash to spend. Both are expected to give a temporary boost to first quarter economic activity.
Charting the Greenback
The DXY dollar index hasn't revisited fundamental support levels at 96 since Halloween. However, it has only seen the major resistance level of 100 twice this year: March 15, and November 30. If the dollar can break and hold that psychologically important 100 level, it opens up the possibility of a run at 102. This is the 61.8% Fibonacci retracement of 2001-2008 decline.
On the other hand, history shows us that when the Fed raises rates at the same time European central banks are easing, there's a 60% chance of the dollar falling. Three of the last five times this situation has occurred, the dollar has lost ground.
At the end of the day, an overly-strong dollar is harmful to the US economy. It prices American goods out of the range of foreign buyers, while leading to increased imports to the US. A stronger dollar makes commodities cheaper when purchased in dollars. Cheaper oil is a deflationary factor for the economy. If the Fed sees deflationary pressures, or signs that the economy is suffering, it will drop the dollar rally dead in its tracks.
The opinions and forecasts herein are provided solely for informational purposes, and should not be used or construed as an offer, solicitation, or recommendation to buy or sell any product.