Dollar's tightening burden

In September 2015, this column argued that Federal Reserve hikes are largely negative for the U.S. dollar once a tightening regime begins. Let’s look at how the U.S. dollar responded to each of the last three Fed tightening cycles (1994-1995, 1999-2000 and 2004-2006) as well as the existing one. One common theme was found.

In the 1994-95 tightening cycle, the Fed began raising rates in February 1994. The U.S. Dollar Index wasted little time, falling more than 10% in the ensuing six months before stabilizing at year-end and subsequently dropping an additional 7%. Among the main reasons for the selloff (despite easy money by competing currencies) was the resulting bond crash, which eroded USD demand. The 10% decline in U.S. equity indices didn’t help the greenback either. Despite seven Fed hikes in 1994, the USD lost 5% to 15% against all major currencies. In 1995, USD lost against all majors currencies, except for the British pound, the Japanese yen and the Australian dollar. 

The 1999-2000 Fed tightening cycle was the most positive for the greenback due to three main reasons: Interest rates took off from a higher level of 5% (compared to 3% in 1999 and 1% in 2006), the Clinton Administration’s “strong USD ” policy consisted of rhetoric backed by US-bound global capital flows and U.S.-Eurozone interest and yield differentials remained firmly in favor of the United States. The “New Economy” espoused by Greenspan’s low-inflation/high-growth paradigm made the U.S. stock market the only game in town as U.S. technology stocks served as a magnet for global capital flows and emerging markets broke down.

The Fed’s 125 basis points in rate hikes in 2004 — kicking off the 2004-2006 tightening cycle — didn’t prevent the USD from having one of its worst years in recent history, falling against all 10 top-traded currencies. 

Already in a two-year bear market, the greenback went from bad to worse due to a swelling trade and budget deficit. A nascent global recovery, led by commodities and their currencies was a major negative for the buck; 2005 proved the only positive exception for the U.S. dollar in the 2-½ years of Fed tightening due to a temporary U.S. tax law encouraging U.S. multinationals to repatriate profits (the rally was also the simple equivalent of a dead-cat bounce). That rally fizzled in December 2005 during the ensuing two years, turning into a prolonged selloff, courtesy of a secular bull markets in commodities and higher-yielding currencies elsewhere.

2015-2017 tightening cycle?

Whether we call this a tightening or normalizing cycle, the current phase is well below prior rounds in frequency and magnitude. After the Fed hiked in December 2015, the U.S. Dollar Index fell 3.5% the ensuing six months. The 7% rebound in the second half of 2016 was largely related to the U.S. election. Yet, when the Fed tightened in December 2016 USD fell 3% after a brief bump. The subsequent bounce ahead of the March 2017 Fed hike was followed by another 3% decline.  

Today, the fundamentals behind tightening are dwindling. Core inflation fell to 0.1% in March, the weakest since 2010, retail sales posted two consecutive monthly declines and payrolls have not seen a 250,000 increase since September 2016. More importantly, few of the Trump Administration policies, which fueled dollar bulls, have got off the ground. Healthcare reform is dead and tax reform appears unlikely to happen on time. Not to mention the mounting U.S. budget deficit and that inflation in Europe and Asia is picking up. 

Finally, if the highly protectionist border adjustment tax bill passes, the European Union and other U.S. trading partners are preparing the groundwork for a legal challenge estimated to be almost 100 times greater than the largest World Trading Organization lawsuit to date. A global trade war becomes more than a theoretical possibility.

The USD Index could reach 94 in such a scenario.