The US Dollar higher by the end of this year

Richard Franulovich, Senior Currency Strategist at Westpac, on US economy and Greenback

There is a better than 50% chance that the Fed will raise interest rates in September. St. Louis Fed President James Bullard told that it should get ahead of the curve, as inflation will rise and labor market slack will end, whilst rates have been kept at near-zero levels for too long. Do you agree with this point of view? What outcomes for the US economy do you expect to see in case of the rate hike?

I would say that I broadly agree with that point of view. I sympathize a lot with James Bullard’s perspective on the US economy and US interest rate. The US recovery is quite mature and even now there is not that much of inflation pressure, and the monetary policy settings are far too accommodative.

Monetary policy is essentially determined at an emergency setting, which is not appropriate even for a lackluster US recovery. Thus, I do not believe it necessarily needs to see a big upsurge in inflation or higher wages. My argument would be that emergency policy settings are just not suitable for the dim US story. That is why the officials should now begin to normalize rates.

Wall Street worries that when the Fed's tightening plans to take hold, a sell-off in the massive U.S. bond market could ensue, and be exacerbated by a lack of bank buyers willing to jump in. However, officials mentioned they do not share this view nor believe that capital rules are solely to blame for the bond market’s growing tendency to seize up. Do you share these concerns? Are there any risks to be worried about?

I believe that in the given circumstance the mentioned concerns are misplaced, due to a lot of reasons. First of all, due to the fundamental basis the inflation outlook is very benign, and the low inflation environment should support bond market in order to prevent yields on rising too far. Secondly, from a flow based perspective, there are a lot of regulatory reasons why this is going to be a big pool of buyers of treasuries.

What will be the major drivers for the US Dollar and what are your forecasts for EUR/USD, USD/JPY and GBP/USD for the end of this year?

We see the US Dollar higher by the end of this year, and we anticipate the EUR/USD to be at 1.05 levels. We see the USD/JPY currency pair at 1.26 levels and we forecast the GBP/USD to be at 1.50. We are looking for broad based Dollar gain through the year end and the reasoning is pretty simple. The US economy is now much more secure and stable.

Moreover, at some point the Fed will begin to normalize its policy and that will become a stark contrast to ongoing asset and QE by the ECB. Furthermore, there is a pressure for the BoJ to expand it purchase programme as well. In addition, we have also got a pretty constructive backdrop for the Dollar to keep fording ahead.