Fed and the USD: A paradigm shift – HSBC

Research Team at HSBC, suggests that the link between US monetary policy and the USD has changed and if we use the old framework for thinking about Fed normalisation, we are likely to make incorrect decisions.

Key Quotes

“In a “normal normalisation” world, the initial rate hikes are indicative of several more to come. In contrast, today the economy is attempting to escape from years of unconventional policy. As a result, the Fed are embarking on an “abnormal normalisation” whereby a rate hike today indicates very little about the timing and degree of future hikes.

This main culprit for this abnormalisation is that FX is now hypersensitive to rates. This causes a feedback loop whereby not only is the FX market being dominated by expectations for future interest rates, but the plausible path for policy rates is being constrained by the strength of the currency.

The USD is now firmly caught in this feedback loop: Currency weakness increases the possibility of a rate hike. This in turn provokes USD buying; however, the resulting USD strength decreases the likelihood of the hike and thus the USD weakens.

This means that buying the USD in anticipation of a Fed hike could be a self-defeating strategy. According to Fed calculations, a mere 4% rally in the USD is equivalent to a 25bp hike. For a market which is debating whether the Fed may move once or twice this year, even a small rally in the USD will swing the abnormalisation process back towards the doves.”