Would Fed tightening boost the dollar?

The recent strength of the dollar has been heavily influenced by growing expectations that the Fed will soon move to raise interest rates as the economy strengthens and inflation starts to pick up. A rising interest rate environment has not historically been positive for the dollar unless bond spreads move decisively in the dollar's favour.

There were four occasions when US interest rates were increased after a period of relatively low rates. In three out of four occasions the dollar was lower rather than higher following the move to higher rates.

The reason for this rather subdued reaction to higher rates probably reflects the response of the asset markets to the tightening. If the move to tighter policy means a generalised rise in global yields, then there is no particular reason for the dollar to benefit. If, however, the rise in US rates is a reflection of higher rates of return in the US alone, then the dollar is likely to rise.

The key for the dollar's response to higher US interest rates appears to be the response of the asset market. If US rates of return rise relative to the rest of the world, the dollar reacts positively; otherwise the dollar is unlikely to benefit.

Of course, if the rise in US rates of return just reflects the cyclical improvement in the US economy relative to the rest of the world, then any rise in the dollar would be temporary, because the structural imbalances would continue to widen.

The latest CPI came as something of a shock to the market, with the core rate rising 0.4% rather than the expected 0.2%. However, this was not the first upside surprise to a US inflation indicator in past weeks. The scale of these surprises is apparent in the HSBC US Inflation Surprise Index. The index tracks inflation surprises across the full range of US inflation indicators.

There are two striking features of this index.

First, between 2002 and early 2004, the vast majority of inflation indicators surprised on the downside. Even when the activity data began to strengthen in the summer of last year, the persistent downside surprises on inflation were probably important in convincing the market that the Fed could sustain low interest rates for a protracted period.

Second, there has been a sharp reversal of these downside surprises since the beginning of February, with upside surprises on CPI, PPI, import prices and the ISM prices paid index. While it is too early to conclude that US inflation is genuinely picking up, it is certainly picking up relative to market expectations.

By tracking the inflation surprise index against the dollar's trade- weighted index since the beginning of 2001, one will find that the downside surprises in inflation since early 2002 have been accompanied by a falling dollar as US yields have fallen relative to the rest of the world. The recent upside surprises have seen the dollar perform better as US yields have risen.

The markets move in cycles and fashions. During the bubble years of 1996 to 2000, equities rallied whil the cost of capital was falling and this led the dollar to chase 'superior' rates of return on offer in the US making the currency a function of the other asset classes. As the bubble burst and equities fell, worldwide corporate balance sheets became stressed and the world was no longer willing to finance the US current account deficit at such a high dollar.

The phase that followed the equity decline generated concerns over deflation causing bonds to rally as short rates and long rates headed even lower and the incentive to hold the dollar continued to diminish.

The point here is that moves in the FX market during all these periods was a consequence of the moves in the other asset classes. However FX was to have its day. Of course all financial markets are inter-related but at some points of time some take primacy over others and from around June 2003 currencies took the primary role.

Deflation fears were at their peak in June 2003 and bond yields on the long end were threatening to fall through 3%. Although there were hints dropped that the Fed may have to resort to extraordinary monetary means, however, it pulled away from this threat and the economic data started to improve and the threat of outright deflation waned and bond yields backed up.

At this point the FX market became the primary financial market instrument. The focus fell on the structure of the US external imbalances and the dollar kept on falling despite an economy that was surprisingly on the upside. The fall of the dollar in the second half of last year happened despite improving economic prospects, a rise in equities of 13% and a 70bp rise in 10-year bond yields.

The focus now is on the Fed and short rates. The first point is that the market is putting fixed income first and FX has lost its leading role. This is a fundamental change in the way the market is viewing the world. Secondly, the focus has now shifted by putting cyclical considerations before structural ones.

For the dollar the switch in thinking is positive because a focus on cyclical issues means the dollar will rise or fall depending on the data.

When the market focus is on structural issues there is an asymmetric bias for a weaker dollar. Renewed focus on cyclical factors is likely to be dollar supportive for now. Ultimately, we expect the US external situation will drive the dollar down, but not today, or tomorrow, or indeed next month, and when it eventually does fall it may be from prices higher than they are at present.

The market focus on cyclical factors makes our economists dollar bullish in the short term as the change in emphasis from the structural to the cyclical has changed.

This report has been compiled by HSBC Bank Malta plc on the basis of economic research carried out by HSBC International Bank's team of economists and financial analysts.