Should Dollar Bulls be Worried About a Changing Fed Stance?

By Mark Meadows, analyst at TopstepFX

 

Over Thanksgiving this week, I have largely taken a break from markets. Even amidst Friday’s huge sell off in Crude Oil, I thought it’s a move that will be better analyzed after seeing Monday’s price action. Holiday weeks are just tough.

But though I was taking time away, one question kept interrupting my tryptophan-induced sleep. Should I be concerned if the Federal Reserve does change its stance on interest rate increases?

To answer this question, I have to set aside the fact that it’s absurd that a short-term tremor in equities will derail the Federal Reserve. Equity markets have come off their highs, but they are roughly flat on the year. There is no cause for panic — at least in the U.S.

That hasn’t stopped traders, pundits and even the President from calling for the Fed to change its stance. They are hooked on easy money and a smooth uptrend in equity markets.

In fact, the Fed will soon have cover if it wants to walk back its pace of interest rate increases. The fall in the price of Crude Oil will reduce overall inflation. Further, it is unlikely that the U.S. can sustain the pace of economic growth in 2018, meaning year-over-year data will start to slow beginning in 2019. The U.S. economy is expected to grow 3.1% in 2018. Comparatively, that growth will fall to 2.5% in 2019.

And same may even argue that the Fed would be right to talk down expectations for further rate hikes. Three hikes in 2019 is ambitious, particularly given the slowing growth in the rest of the world — a trend that is even more troubling in emerging markets.

Base Case: Fed Talks Back 2019 Hike Potential

This is my base case scenario: the Federal Reserve hikes in December as planned, but softens its language to indicate that it is data dependent on the path of interest rates in 2019. It may hike three times; it may not.

That allows the Fed to assert its independence and maintain that it will not bow to political pressure. Instead, it will do what the economy demands that it does in line with its dual mandates for price stability and full employment.

at does that do to the U.S. Dollar?

On the surface, it’s a clear answer. Any less than three rate hikes next year, and the U.S. Dollar will suffer. That’s what the market has priced in. That’s why the Dollar has seen a strong 2018 already.

But look at the expectations for the U.S. compared with its rivals. If the Fed doesn’t raise interest rates three times, it’s because growth is slowing. And growth in Europe and emerging markets is already slow.

Say the Fed raises rates twice next year for a total of 0.5%. In Europe, they are pricing in expectations that rates go just 0.10% higher. That is still quite a divergence.

In addition, if the Fed did leave some room for the realization that things may go wrong in the global economy, that could even help out the U.S. Dollar, which could benefit from safe-haven flows.

Outside Case: Fed Bows to Pressure, Stops Hiking Rates After December

It’d be hard to imagine that the Federal Reserve would make this move and the U.S. Dollar would not have a knee-jerk reaction lower. That’s a clear risk for a Dollar bull.

But what does that ultimately mean for the global economy and the stance other central banks will take? It’s not good. If the most bullish central bank in the world (the Federal Reserve) turns cautious, what will the Bank of Japan do? What will the ECB do? It’s hard to think they would not also turn more accommodative.

Further, if things go really south, then that actually increases global demand for U.S. Dollars as the world’s reserve currency. So, while it would be immediate Dollar negative for the Federal Reserve to shift policy to a neutral stance, it may not be so longer-term.

The Technicals: The Bearish Trend is Clear

Inside the EUR/USD, it’s hard to see a bullish trend emerging. In fact, the pattern that developed on a daily chart (below) seems pretty clearly to be a head and shoulders. And the neckline has broke.

From a theory perspective, that could mean that the U.S. Dollar would target an area equidistant from the neckline to the head. In this case, that equates to $0.13, a move that would send EUR/USD to parity.

That is not the move that I am forecasting. Instead, I think a further decline to the 1.08/1.09 area to fill the gap created in April 2017 would be much more likely in the near term — even if the Fed turns a bit more dovish.

Mark Meadows is a forex trader and analyst at TopstepFX, which provides live trading capital to retail forex traders. Traders never make any capital contributions to their live trading account. To learn more, go to https://www.topstepfx.com/.