The dollar long con

As the Fed looks to cut interest rates further, the general thinking is that it should weigh on the US dollar. But with traders pricing in ~163 bps of rate cuts by June next year, is there really much more to squeeze out of this trade?

If the Fed goes by 25 bps every meeting from here, that’s only another 150 bps of rate cuts to go until then. It indicates that market players are hoping for a little more and that’s also evident by the initial 50 bps push for November. Those expectations have been pared back a fair bit now after Fed chair Powell’s remarks yesterday.

The thing is, there’s now two sides in looking at all of this.

On the one hand, history shows that markets have a tendency to overprice or underprice Fed moves during any cycle. Here’s a quick example of that:

You can see that since 2016, markets tend to get it wrong about Fed expectations particularly during the early and late stages of the cycle.

Even from the above pricing, it showed Fed funds futures expecting the central bank to cut early in 2024 but look where we are now. The first rate cut only came last month, albeit being a 50 bps move. But it was certainly not the six rate cuts as planned back in December last year, with the first rate cut supposedly to come in during March.

So, that’s one thing.

The counter-argument to that now is that the Fed has shown that it can be bullied into a decision, especially if the data supports the narrative that market players are identifying with.

Since Jackson Hole, policymakers kept leaning towards the likelihood of cutting rates by 25 bps in September. However, when it came to decision day, they decided to go with 50 bps and blurt out whatever argument to support that.

The simple fact is that the Fed has revealed a tendency to not upset market expectations. It wouldn’t be the first time and it possibly won’t be the last either.

Sure, there was the argument that moving by 50 bps last month is the lesser of two evils. It toned down the risk of markets kicking and screaming. And if the data did get worse, they could argue that they are not behind the curve in stepping it up big in the first move.

However, that is now pushing markets to thinking that they might keep going more aggressively going into next year.

That was evident by another 50 bps push by market players for November, in which Fed chair Powell tried to play down yesterday. But will he really back down if the data softens in the weeks ahead?

In any case, even as the Fed cuts more aggressively now, the point is that the US economy is still heading towards a soft landing. And that will likely put a floor on where we will see the Fed funds rate end up in the next year or so.

So long as the US economy holds up, there’s a good chance to see rates hold at around 3% or higher at the very least.

And if you compare that to where rates will be heading towards for other major economies, the US will actually end up sitting in a pretty decent spot.

The BOE, RBA, and RBNZ are still contenders for now but they’ll have to catch up when the needle starts to move even more in their respective cycles.

Then, the ECB is the ECB and the SNB has already brought rates down to 1%. The main one to watch is for the BOJ but it looks like their window might be closing soon. They might be able to squeeze in another 25 bps or 50 bps at the most, but that won’t be nearly enough to convince of a major shift in the rates narrative once the dust settles.

The only other issue for the dollar might be that emerging markets might not cut rates as heavily as well during this cycle. And that could see less recovery flows in the dollar if hot money continues to get parked there during this outflow period.

The dollar might be at the bottom of the pile in the last month or so but in the bigger picture, it might not actually end up being that bad for the greenback. Come what may, there is a distinct possibility of the dollar ending up being the cleanest shirt amongst the dirty laundry again.

That is typically what we have come to associate the dollar with over the last six or seven years. And once the dust settles on all the rate cuts we’re seeing, it could be exactly where we end up again with the dollar.

I reckon that’s the hope and most bullish outlook I can make for the dollar currently. And that is to play the long con.

This article was written by Justin Low at www.forexlive.com.