USD in a Tightening Cycle
As the market digests a significant uptick in December FOMC rate move frenzy with implied probabilities now pricing a 68% chance of a move a near doubling from the pre NFP release pricing of 36%. The move in the market pricing was stimulated by the bumper 271,000 headline number and the robust reading on the employment rate and hourly wage growth. It would appear an opportune time to review historic USD performance when the FED tightens to give some perspective on what we can potentially expect if the FED lifts off in December.
History Rhymes If Not Repeats
Historically the USD somewhat counter intuitively failed to garner the support one would anticipate when the FED tightens rates. Although, there are two notable exceptions which were the USD periods of appreciation witnessed in the early 1980’s and late 1990’s, during these tightening cycles the USD significantly outperformed it’s FX major counterparts.
The unique element of the current environment is that the Federal Reserve will most likely be tightening policy into an era where the vast majority of global central banks are either enacting or planning to enact easing policies. In such a plainly divergent economic policy position the rush into the USD has been palpable, especially since the summer of 2014 with the ECB signalling for the first time their intention to move to an accomaditive monetary policy. This begs the question as to whether or not the meat of the USD move has already manifested.
The First Twelve Months
Since the removal of the Bretton Woods agreement in the 12 months after an initial FED move the USD has registered modest gains with a notable exception being in its trade against the Japanese Yen where the average returns in the 12 months post a move is actually negative 4.5% while the trade weighted USD Index demonstrated a modest positive 1.9%.
It is particularly pertinent to note that the two most recent cycles of FED tightening during 1994 and 2004 the initial 12 month returns on the trade weight USD Index were negative 5.8% and 3.5% respectively. However, during the the major USD bull cycles from 1982-84 and 1998-2000 the USD registered double digit gains of eleven point five and thirteen point five percent gains respectively.
JPY Doesn’t Buy It
It is certainly of note that in all these cycles the one outlier is the performance of the USD versus the JPY, which consistently demonstrates the best performance against the USD during FED tightening cycles.
It is also of note that this is the first time on record that the FED may effectively raise rates into a commodity price collapse, a unique element of this particular cycle is the fact that China is now the principle driver for commodity demand whereby in every previous cycles the commodity demand drive came from the US. So in this instance commodity prices and the commodity proxy FX pairs don’t have an inherent protection from the effects of stronger US growth that has historically been witnessed during a FED tightening cycle. The dramatic declines in commodity related FX has been largely precipitated by the China growth concerns most recently witnessed during late summer. The China growth concern story and its related impact on commodity pricing coupled with a FED move could prove significant for commodity FX pairs.
FED First Mover Advantage
The cycles where the USD under-performed were those where the FED effected tightening policy in an environment where the other major central banks were also undergoing tightening of their domestic monetary policy, this clearly isn’t the case in the current climate, where initially it appears the FED will be a sole actor in removing its accomadtive stance. The one exception here is that the Bank Of England which may closely follow the FED with an outside chance that the Bank Of England could front run the FED.
On balance the historical pattern would portend that the USD is likely to register further gains on the initial FED move, however, the patterns also suggest that much of these gains have already been registered suggesting more limited upside in the near to medium term. This is most likely to be more pronounced against the JPY where the USD has most often struggled to capitalize on a FED move. It is also likely that the SD could prove sluggish against the GBP as the BOE maybe the next central bank to follow suit and hence the USD may under perform against Sterling.
Trading Take Away
From a trading perspective we are now tracking the bullish USD playbook highlighted in last week’s update
- The bullish view would see the current upswing extend through the primary resistance level highlighted on the chart expand towards and test the year to date highs, I would anticipate some supply here on the first test but expect the pull back to be shallow and hold the prior descending trend line resistance as support before a trend continuation move develops as per the chart below
Here is last week’s chart with the probable price path highlighted
And here is where we stand today
We have yet to test the year to date highs and price is taking a breather from the post NFP impulse extension. The current price action is indicative of a bull flag pattern on the daily chart and the high probability is for a further extension to test year to date highs next.
- I will continue to monitor the price pattern highlighted in the chart above looking for a test of offers and stops at or just above year to date highs. I will then be looking for a pullback to test and hold the breakout area around 98.00, where I will venture long for a sustained break of 100.00
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