The Dollar In The Week Ahead

The US dollar bottomed against nearly all the major currencies on May 3. The hawkish April FOMC minutes that began swaying opinion about the prospects for a summer rate hike were not published until two weeks later, and the confirmation by NY Fed President Dudley was not until May 19. 

Nevertheless, the shift in expectations for a resumption of the Fed’s gradual normalization of monetary policy is a potent force that has fueled the greenback’s recovery. The place to look for investors’ anticipation of a rate hike is not in the long-end of the curve but the very short-end. For medium and long-term investors, it is immaterial whether the Fed hikes in June or July. The implied yield of the August Fed funds futures contract (which is the closest proxy for June and July) has risen 15 bp, while the US 2-year yield has risen 20 bp.  

Anything that shifts these expectations would impact the dollar. There are two broad categories of events that could alter expectations for US monetary policy:  foreign and domestic. The biggest foreign threat, which several, though not all, Fed officials have identified is the UK referendum on June 23.  

Even though a vote to leave the EU would not entail an immediate separation, but rather begin a two-year negotiations that would lead to the dissolution of the marriage, it could cause a significant disruption in the global capital markets.  The recent polls appear to have suggested a shifted away from Brexit. Yet even if there is a 20% chance (the events market, PredictIt has it as 22%) of UK voting to leave the EU because the potential impact could be so serious, policymakers, like investors, have to take it seriously. 

Through a risk-management point of view, the question facing Fed officials is what kind of error is preferable, assuming the economic conditions for a rate hike exist. The Fed could raise interest rates, and the UK could vote to leave, and there could be a significant increase in volatility and a tightening of financial conditions. The Fed could wait for its next meeting, six weeks later to hike rates, and the UK votes to stay in the EU and there is not instability in the financial markets. Assuming rational actors, we think that the Fed would prefer the second error than the first.  

OPEC meets on June 3. Investors and observers recognize that there is little chance of an agreement to freeze output. While most producers have little spare capacity, the key remains Saudi Arabia. On political and economic grounds it cannot cede market share to Iran. Moreover, the combination of Saudi Arabian influence and the cooling effect of US financial sanctions (as opposed to the embargo that has ended) are contributing to a more gradual recovery of Iranian output. 

With oil prices near $50 a barrel, Saudi Arabia’s strategy of squeezing out high-cost producers would seem to be working. US production has fallen by around 500k barrels a day, but the other supply cuts have not been the result of lower prices and the Saudi strategy. Libyan and Nigerian oil output has fallen due to domestic violence. Canada’s output fell due to forest fire and is already coming back online.  

The outcome of the OPEC meeting will have little impact on whether the Fed decides to hike rates in June or July. The meeting is still important because it will be an opportunity to see/hear Saudi Arabia’s new Energy Minister Khalid Al-Falih who replaces Ali al-Naimi who had the position for the past 20 years. Al-Falih is reportedly a close confidant of Prince Mohammed, who has emerged as a key figure driving the Kingdom’s policy.