By Jamie McGeever
ORLANDO, Florida (Reuters) – The dollar has been floored by an aggressive repricing of the U.S. interest rate outlook, but it is probably too early to discount the greenback.
The dollar is currently languishing at its weakest level of the year against baskets of major and emerging market currencies, raising the question: Can this bearish momentum be sustained?
Viewed through the lens of relative interest rates, the answer is almost certainly “no.” The depth and speed of Fed easing now priced into the US futures curve appears exaggerated, on an absolute basis and especially in relative terms.
Traders now expect more than 200 basis points of Fed rate cuts by September 2025, and for the Fed Funds rate to reach its so-called terminal level of just above 3.00% the following year.
This assumes that the Fed will comfortably continue the most aggressive policy easing campaign of the G7 countries.
Traders are also pricing in a one-in-three chance that this easing cycle will begin next month with a 50 basis point rate cut. In the history of the modern Fed, such a large initial cut has only occurred during emergencies and crises.
To be fair, US markets have just suffered a massive volatility shock, and major downward revisions to employment growth indicate the labor market is creaking. So it is possible that markets are more vulnerable than previously thought.
But it would likely take much more than a modest slowdown to justify the size of the easing traders now expect.
IT’S ALL RELATIVE
As the saying goes, when the US sneezes, the rest of the world catches a cold. But interest rate traders seem to assume that the rest of the world has developed some immunity to US weakness.
While other major central banks such as the Bank of Canada, the Bank of England and the European Central Bank have already started cutting rates, their expected rate paths are shallower than the Fed’s. In some cases even significant.
The BOC is expected to cut a further 180 basis points, the ECB by 165 basis points, the BoE 135 basis points, the Reserve Bank of Australia 100 basis points and the Swiss National Bank 60 basis points, based on their respective policy rates and implicit terminal rates.
If these assumptions are already reflected in the price of the dollar, further dollar weakness will require the US economic outlook to become bleaker and for this shadow to somehow fail to spread over other countries and currencies. spread.
As George Saravelos, head of currency research at Deutsche Bank, notes, the US economy continues to grow at a decent pace compared to its major rivals: the eurozone is flirting with stagnation, and China is flirting with deflation.
“We see a much shallower US easing cycle than priced. Risks appear to be shifting to a more aggressive Fed,” Saravelos said.
KEEP IT REAL
A look at annual inflation in the G7 countries shows that central banks’ 2.00% targets are within reach. But while the Fed can give itself a well-deserved pat on the back, inflation in the US is higher by some measures than in any other G7 economy.
This could still limit the extent and speed of policy easing, lifting the dollar off the 2024 low.
It’s true that “real” US interest rates are high and have plenty of room to fall if growth slows. Factoring in annual CPI inflation, the real federal funds rate is approaching 3.00%, the highest since 2007.
Stephen Jen of Eurizon SLJ Asset Management is one of many analysts who believe that historically high real rates will allow the Fed to do some major easing. In that case, the current weakness of the dollar is justified.
“There will come a time when the market will overshoot too much too quickly again, but I suspect we’re not there yet,” says Jen.
But even if one agrees that the current projected path of rate cuts could materialize, that is already priced in. It is difficult to imagine that we would see greater easing, barring a real crisis.
And again, you have to wonder what will happen elsewhere. Real interest rates in other countries are also at their highest levels since the global financial crisis. Granted, many of these are lower than US rates, but some, such as the BoE’s ‘real’ rate, are at the same level.
Predicting currency movements can be like tossing a coin, as former Fed Chairman Alan Greenspan once noted, so you need to show some humility. But it’s safe to assume that if the Fed cuts more slowly than expected, the dollar will come out of the ropes and fight back.
(The views expressed here are those of the author, a columnist for Reuters)
