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The dollar rally is back as Yellen turns hawkish

by City Index

Janet Yellen, the head of the Federal Reserve, said that she is still happy to hike interest rates later this year during her semi-annual testimony to Congress last week, also known as the Humphrey Hawkins testimony. Since financial markets are extremely sensitive to comments from Janet Yellen, if she remains hawkish in the coming weeks and months then we could see a return of the dollar rally.

At the last FOMC meeting, Fed officials seemed to be evenly split on whether rates would increase once or twice this year. Janet Yellen’s assessment that rates would rise at some point in 2015, is thus not a big surprise. However, what is driving dollar strength on the back of her testimony is her insistence that US interest rates will rise even though we have seen a spate of weaker US economic data, including retail sales alongside some potentially serious external risks.

The Federal Reserve seems willing to look through external threats such as a Greek default and exit from the Eurozone, along with China’s recent bout of stock market volatility. At this stage, the Fed seems happy that events won’t spiral out of control and disrupt financial markets. Thus, it may take a major negative outcome in Greece or China to disrupt the Fed from starting its rate hiking cycle later this year, which the market is taking as a hawkish signal.

Although the Fed seems comfortable with signalling a rate hike is possible this year, potentially even two hikes, the financial market seems less comfortable. We can gauge financial market expectations for US interest rates by looking at the Federal Funds Futures market. This market is expecting barely one rate hike by the end of the year, which is less than some Fed members expect.

So who is right? Typically when the market has muted expectations for rate hikes a currency can struggle to appreciate. This is one reason why the dollar rally that started in June 2014 has struggled to maintain momentum since March.

However, if the market starts to believe that Yellen and co. at the Federal Reserve are committed to rate hikes this year then this could translate to financial markets feeling more confident about higher rates by the end of the year, which may extend the dollar rally.

We think that the EUR and the JPY are most at risk from dollar strength in the coming months. This is because the ECB and Bank of Japan are both maintaining dovish, highly accommodative monetary policies for now, which contrasts with the Federal Reserve’s tightening stance. Typically when a central bank tightens interest rates a currency can rally, while a looser central bank policy stance can lead to currency weakness.

If the Federal Reserve maintains its slightly hawkish bias, then we could see EUR/USD fall, even if the Greece crisis is resolved. We believe that a move back to 1.05-1.06 is possible if we see the Federal Reserve hike interest rates this year and the ECB stick to its QE programme. Against the yen we expect the dollar continue to outperform. If we break above the 5th June high at 125.86 then we may see back to 130.00 in the coming weeks.

Gold could also be impacted, as interest rate tightening by the Federal Reserve could erode the need for an inflation hedge, since higher interest rates can choke off inflation pressures down the line. Thus, if we see the Fed stick to its guns and hike rates then we could see a sell-off in gold in the coming months that may open the way for a move back towards $1,000 per ounce in the event of a rate hike in the US in September.

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