In this article, we argue that a significant shift of interest rate expectations in favor of the U.S. dollar has been the main driver behind the recent strength of the greenback. We expect the Fed to increase rates by 144 bps in the next 18 months and dollar strength to continue.
A Sudden Shift in Interest Rate Expectations has been helping the U.S. dollar
This week, several of the world’s most important central banks announced their interest rate policy. Yet, despite their different economic circumstances, they all decided to keep rates unchanged. In fact, the Federal Reserve kept rates at 2%, the ECB at 4.25%, the BoE at 5% and the RBA at 7.25%. So if there were no major surprises why the U.S. dollar rallied so much during the last two weeks?
The average daily trade volume in the foreign exchange is almost US$ 4 trillion and trying to identify the trigger behind such a sharp dollar appreciation is no easy task. Nonetheless, we think that a significant shift of interest rate expectations in favor of several interest rate hikes by the Federal Reserve has been the main driver behind the recent strength in the greenback. However, trying to judge which central banks will be more aggressive in 2008/2009 is hard to measure. In this article, we argue that interest rate expectations can be measured by using Libor rates with different maturity. Indeed, by comparing several interest rate term structures across the globe one can have a good idea on how many rate cuts or hikes different central banks have reserved for us in 2008/2009. Judging by the study we did posted below, the U.S. Federal Reserve will be one of the most aggressive central banks and we expect them to increase rates by at least 144 bps in the next 18 months. On the other hand, traders are now pricing a series of rates cuts by the Reserve Bank of New Zealand and also by the Reserve Bank of Australia which could make their currencies very vulnerable to a carry trade unwind. But Is This The Dollar Breakout?
Written by Antonio Sousa, Chief Strategist
Questions? Comments? E-mail: asousa@fxcm.com
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