Dollar Bulls' Argument Undermined by Fed's Trade-Weighted Index

  • Central bank's measure reaches strongest in 12 years
  • Climbing Fed gauge backs case for gradual rate increases

There’s a rift erupting between the dollar as measured by the Federal Reserve and the greenback that currency investors care about.

From the Fed’s perspective, the U.S. currency is soaring. The central bank’s trade-weighted gauge reached a 12-year high on Dec. 11 as a rout in emerging markets propelled the greenback against the currencies of a broad swath of U.S. trading partners, including China and Mexico. On the other hand, the dollar is tumbling against the euro and the yen, some of the world’s most-transacted foreign-exchange pairs.

While most economists expect the Fed to lift borrowing costs from near zero on Wednesday, a strengthening trade-weighted dollar may limit how aggressive this cycle of interest-rate increases may be. The 10 percent appreciation this year in the Fed’s dollar measure is already doing part of policy makers’ job: It’s reducing the cost of imported goods, making it harder for the Fed to achieve its 2 percent inflation goal.

"The Fed may want to move on with its hiking-cycle plans, but really very clearly a gradual approach to this tightening cycle," Alessio de Longis, a money manager at the global multi-asset group of New York-based OppenheimerFunds Inc., said on Bloomberg Television. "The risks here are for a dovish hike, which may send the dollar lower, particularly against the euro and the yen."

Divergence Defiance

A gradual pace of Fed increases may challenge the monetary-policy divergence trade that has fueled the dollar’s ascent against major currencies in the past 18 months. Investors have already started to question the case for dollar gains versus the euro and yen this month after the European Central Bank disappointed some traders who were looking for bigger monthly bond purchases.

Intercontinental Exchange Inc.’s U.S. Dollar Index, which serves as the benchmark for various futures and options instruments and has a 71 percent weighting on the euro and the yen, is down about 2.4 percent in December, trimming the surge since mid-2014 to about 23 percent.

This isn’t the first time the dollar has rallied against emerging-market trading partners while retreating versus the most-traded major currencies.

The dueling gauges, which tend to track each other historically, showed a similar divergence in the weeks before the Fed’s Sept. 17 policy decision. China’s shock yuan devaluation in August roiled global markets and sent the dollar soaring on a trade-weighted basis. The Fed bowed to market volatility at the time and refrained from raising rates, a decision that eroded some investor’s confidence in the central bank.

"The loss of credibility would be too great if they were to back off the rate hike now," said Brad Bechtel, a managing director at Jefferies Group LLC in New York. "But it doesn’t mean the market will not test their resolve anyway."

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