Dollar Weakness and Fed Expectations

<br /> Dollar Weakness and Fed Expectations – Marc to Market<br />


The US dollar has fallen against all the major currencies this
Even the pound has gained about 0.3%
against the heavy greenback.  
What is most
striking about the dollar’s decline is that is has taken place despite a modest
upgrade of the odds of a Fed hike. 
 Consider on the broadest level, the
Dow Jones polls that found 71% expect a rate hike before the end of the year
compared with about 50% in the July survey.  
The odds
implied by the pricing of the Fed funds futures have also increased. 
 They increased after the stronger than expected
employment report early in the month but
fell back off after the disappointing retail sales report and some seemingly
dovish comments by a few regional Fed presidents. 
However look at
what has happened over the past ten days.
  On August 12, the odds that Fed
funds target will be 50-75 bp in September, November and December respectively,
were 16%, 17.5%, and 36.8%, according to
Bloomberg calculations.  Now, after some robust data and seemingly more
hawkish comments by Fischer and Dudley, two-thirds of the Fed’s Troika (Yellen
speaks at the end of the week at the Jackson Hole confab) that odds have increased
to 26%, 30.1%, and 41.9%.  
There is
precedent for the Fed to adjust policy in September of a national election
year, but there is no precedent for a November move. 
 Everyone seems to recognize this.  We think it
is a misreading of the odds to suggest that there is a greater chance of a hike
in November than September.  This quirk is not the result of thinness of
interest in the contract as turnover is second only to the October contract.
Given that the FOMC meeting is late in September (20-21), we suspect that some
participants use the October contract to express a view (or take out insurance)
for the September meeting.   
The November
contract may be more of the same, with two additional considerations. 
 First, the reforms of US money markets are to be
completed by the middle of October.  This adjustment is a factor has
lifted the Fed funds average effective rate 40 bp, a few basis points above
where it was in the first part of the year.  Second, insurance companies
are expected to announce an increase in premiums in late-October or
early-November.   It is not clear why the latter would have an impact on
the expectations for the effective Fed funds rate in November, but we see some
references to it.  
The US-German
2-year interest rate, which over time, does a reasonably good job of tracking
the euro-dollar exchange rate, has widened to 136 bp from a low of 125 bp earlier in August. 
The 100- and 200-day moving averages converge at 130 bp.
 In our experience, the rate differentials often lead the currency
More recently,
it has been popular to turn this argument on its head. 
 Because of the wide interest rate differentials (and
swap rates), it is expensive to hedge dollar-denominated investments for
Japanese and other investors.  Indeed, the TIC (Treasury International
Capital) report showed that China and Hong Kong sold $28 bln and $11 bln of US
Treasuries respectively in June.  Japanese investors sold $13 bln.
However, what
is the most striking element in the TIC data was that all of the Treasury
selling came from officials (central banks),
not the private sector. 
 Specifically, the data showed that
$32.9 bln of Treasury bonds and notes were sold
in June, and
officials sold $33.5 bln.  The private
sector bought $2.35 bln of US Treasury bonds and notes.  The Cayman
Islands, where many hedge funds are based, for tax and regulatory arbitrage
purposes, bought $27. 3 bln of Treasury
bonds and notes in June.  

the amount of Treasuries that the Fed holds as a custodian for foreign
officials increased slightly in June.  
They stood at $2.904 trillion at the end of May and $2.912
trillion at the end of June.  At the end of July, the Treasuries in the Fed’s custodian account stood at $2.898
trillion and $2.877 trillion as of August 17. 


Dollar Weakness and Fed Expectations
Dollar Weakness and Fed Expectations

Reviewed by Marc Chandler

August 22, 2016

Rating: 5

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