Interest rates may have reached a peak.
The Fed (FOMC) lined up with the central banks of Europe and Japan in leaving interest rates unchanged at its most recent policy meeting on Wednesday, November 1st. The next morning, the Bank of England followed suit, announcing no changes to current base lending rates. This situation has led many analysts to claim that global interest rates have peaked. Those who expect higher rates generally believe that any additional rate hikes will be modest.
Before the Fed’s announcement on Wednesday, the US dollar (DXY) was trading near its highest level of the year. The dollar retreated on the news but remained within the bounds of its recent trading range (105.5-107.2). Currently, the dollar is up by about 2.5% for the year.
Central bankers have increased their lending rates aggressively over the past 15 months and global rates are at levels last seen over 20 years ago. Monetary policy is historically lagging in nature, so the current pause is being explained as a chance to let prior tightening work its way through the various economies. Global Inflation has mostly shown signs of subsiding but remains above the shared target level of 2%. Higher rates have had dampening effects on economic activity in current events, but the US appears to be holding up better than Europe and Japan.
Likely Path for the Dollar in the Next Quarter
The dollar has been trading in a range for the past seven weeks as markets anticipated and received the news that central banks have generally paused additional hikes for now. FX volatility has contracted, meaning that markets expect near-term moves to be relatively small. From a technical point of view, a breakout of the recent range suggests moves to longer-term support or resistance levels. From current prices that implies a potential gain of 4% or loss of 7% over the next two quarters.
The direction of the dollar over the next few months will be driven by unfolding economic data as the markets continue to assess the effects of high interest rates on growth and inflation in the developed world.
Europe is Slowing
The DXY index is heavily weighted in favor of the euro, so events from Europe could have an outsized influence on the fate of the dollar. Recent economic reports from the continent have shown a weakening manufacturing sector and slowing demand for goods and services. At the recent European Central Bank meeting, ECB President Lagarde said, "The economy is likely to remain weak for the remainder of this year,” and, “The risks to economic growth remain tilted to the downside.” However, she added that, “Domestic price pressures [inflation] are still strong.” Most analysts expect the ECB to sacrifice growth to contain inflation, suggesting that the ECB will keep rates at current levels unless there is dramatic evidence of a collapse in economic activity.
Robin Brooks, Chief Economist at the Institute of International Finance, has posited that the euro is overvalued by nearly 15%, and expects EURUSD to drop to 0.90. If instead the euro moves higher in the coming months it could challenge the mid-2023 high of 1.13.
Japan and “Normalization of Monetary Policy”
Japan has been the outlier among industrialized countries, keeping short-term rates in negative territory and holding down long-term rates through ongoing yield-curve control (essentially quantitative easing). This divergence has led to the yen losing over 30% against the dollar since March 2022, and a year-to-date loss of 15% in 2023. By most measures, the yen is significantly undervalued against the dollar (including The Economist’s Big Mac Index, showing the yen 43.2% undervalued). Japan has indicated its intent to bring monetary policy more in line with its trading partners, but the process is expected to be incremental and not begin until the early second quarter of 2024. From current levels (USDJPY 150), any perceived tightening should result in an appreciating yen. Markets are forward-looking so the yen will likely start to move higher before policy changes occur.
China and the Global Economy
Any discussion of global macroeconomics needs to include the impact that China will have on the world economy. Recent reports indicate that China remains mired in a sluggish economy that has not rebounded post-Covid. China, like Japan, has kept interest rates at levels significantly lower than other industrialized nations, with the yuan dropping by nearly 6% against the dollar in 2023. China maintains strict controls on its currency, but the yuan has been remarkably correlated with the Japanese yen. If the yen appreciates, expect the yuan to follow suit.
Low FX Volatility Creates an Opportunity
Markets appear to be pricing in a period of stable interest rates, and FX volatility has been contracting. Many technicians forecast quiet conditions, at least until the start of 2024. Low volatility means that options prices will drop. This presents an opportunity for FX risk managers and finance departments as the cost of hedging with options will be lower during what may be a calm before the storm.
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