Dollar's Backtrack Gives Fed Room to Focus on Higher-Rate Path

  • Bloomberg gauge of U.S. currency near lowest since October
  • Hedge funds pare bets on currency strength to least since 2014

The Shift in Market Expectations for Fed Rate Hikes

For all the hand-wringing by Federal Reserve officials over the strengthening dollar, foreign-exchange traders are signaling the currency’s two-year ascent is running out of steam.

Hedge funds have cut wagers on the greenback to the least since July 2014 as the dollar dropped to the lowest level last week in more than four months. Forecasters have followed, cutting their estimates for the currency. The shifts are giving Fed policy makers their clearest signal yet that they have scope to map out another interest-rate increase this year.

“It enables the Fed to execute further tightening,” said Jennifer Vail, head of fixed-income research in Portland, Oregon, at U.S. Bank Wealth Management, which oversees $125 billion. “I don’t think the dollar’s a concern.” Vail said she favors the dollar versus the euro heading into policy makers’ Tuesday and Wednesday meeting.

QuickTake Fed Liftoff

The push-pull of the dollar on the Fed, where a stronger currency erodes impetus for officials to raise rates by tightening financial conditions, and a weaker currency does the reverse, is tipping in favor of higher rates in 2016. The slumping greenback is rewarding central bankers who’ve stuck with plans to raise rates gradually, even after a trade-weighted measure of the U.S. currency touched a 13-year high in January. Futures show a 80 percent probability of a rate increase by year-end, up from 30 percent odds a month ago.

Fed Focus

The Bloomberg Dollar Spot Index, which tracks the U.S. currency versus 10 peers, has fallen 1.9 percent this year. The central bank’s broad trade-weighted measure of the greenback tumbled 1.5 percent in the first week of March, the most in a year, taking the gauge down about 4 percent from the January high.

Large speculators reduced positions that profit from gains by the dollar against eight major peers to a net 112,848 contracts in the week through March 8, the least since July 2014 and down from 428,298 contracts in November, data from the Commodity Futures Trading Commission show. Median forecasts compiled by Bloomberg show analysts expect an Intercontinental Exchange Inc. gauge of the greenback, which tracks the currency versus six major peers, to advance to 98.1 by Dec. 31, from 96.7 on Tuesday.

Fed Attention

The dollar’s appreciation has captured the Fed’s attention, particularly as it relates to inflation. Policy makers discussed the strength of the greenback at all eight of their meetings during the past 12 months, with consideration seemingly peaking in September, when the central bank’s minutes mentioned the currency more than 20 times.

The prices for goods and services that consumers buy, excluding food and fuel, rose 1.7 percent from a year earlier in January, exceeding the Fed’s forecast of 1.6 percent for the end of 2016, a report showed Feb. 26. Their goal of 2 percent inflation is back in reach with Fed Vice Chairman Stanley Fischer saying last week that “we’re not that far away,” and that inflation will rise after the dollar and oil stabilize.

“What we’re seeing in the dollar, what we’re seeing in oil, actually emboldens them in terms of telling the markets ‘We told you so’” on inflation, said Paresh Upadhyaya, director of currency strategy in Boston at Pioneer Investments, which oversees about $236 billion and is betting on dollar gains. “The market is underestimating the Fed tightening cycle.”

Turning Positive

The Bloomberg U.S. Financial Conditions Index, which tracks financial-market stress, turned positive last week for the first time this year, boosted by a rally in stocks and corporate credit.

Rate increases are back in the cards this year as a result. While Morgan Stanley sees the U.S. central bank waiting until December to move, futures show traders pricing in a 54 percent probability of an increase in June, up from just 6 percent a month ago.

“Dollar strength has been seen to restrain the Fed in some way, but I think, obviously, so far this year, the dollar appreciation has very clearly unwound,” Michael Metcalfe, global head of macro strategy at State Street Global Markets Ltd., said on Bloomberg Radio. “Some of the reasons why the Fed shouldn’t have been tightening have gone.”

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