Fed: Pick up in pace of rate hikes could make further USD upside more difficult - MUFG

Lee Hardman, Currency Analyst at MUFG, suggests that the market is already discounting a significant pick up in the pace of rate hikes which could make further US dollar upside more difficult.

Key Quotes

“The risk of further disappointment has increased as the market has adjusted to discount more significant tightening expectations of between two and three hikes by the end of next year, and between four and five by the end of 2018. It would already represent a significant pick up in the pace of tightening in the coming years after it has taken a year to follow up the first rate hike. There is now a higher hurdle for Fed policy to continue providing upward momentum for the US dollar in the year ahead.”

“On balance, we believe that there is less risk of disappointment on this occasion which supports our view that the US dollar will continue to strengthen during the first half of next year. Firstly, we believe that the risks to both US growth and inflation are more skewed to the upside which will be reinforced by looser fiscal policy under President elect Donald Trump. The Fed is closer to meeting both sides of its dual mandate strengthening the case for tighter monetary policy. Higher wage and money supply growth highlight that inflation risks continue to build.”

“Secondly, international developments have turned more favourable with global growth currently picking up. Most notably downside risks to growth in China have eased during this year. The negative shocks to the US economy from the sharp drop in the price of oil and stronger US dollar have also eased. The price of oil has increased by around 50% this year and the US dollar is only modestly higher than it was over a year ago despite recent sharp gains.”

“Thirdly, the relative appeal of the US dollar should be boosted further by heightened political risk in Europe during 2017. Elections in the Netherlands, France, Germany and a potential early election in Italy are likely to further undermine the euro which is the main alternative reserve currency to the US dollar. The market will be fearful over the rise in popularity of anti-establishment and eurosceptic parties which could threaten the future of the euro. In these circumstances, we remain confident that EUR/USD should finally break below parity by the middle of next year. The door has opened up for further downside in the near-term after key technical support from the cyclical low in March 2015 at 1.0458 has just been broken.”