What’s next for the Fed? Dagmara Fijalkowski, Head of Global Fixed Income & Currencies, explores how long this rate-hiking cycle could last. Dan Mitchell, Portfolio Manager, comments on how these rate hikes could affect U.S.-dollar strength.
Watch time: 5 minutes 34 seconds |
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How long will this rate hiking cycle last?
With the first hikes behind us, now the question is how many more hikes there will be in this cycle. At the minimum, the Fed will hike to a so-called neutral fed funds rate. But central banks often hike more into restrictive territory. The peak rate in a cycle is referred to as a terminal rate. So terminal rate is higher than neutral, but it’s only known after the fact. What happens is that once the Fed hits terminal, they would have pulled too much liquidity from the economy or economy is slowing right into recession. And then the central bank has to backtrack with a few cuts.
In 2019, seven months after the last hike, the Fed cut on three consecutive occasions by 25 basis points each time. It’s important to know that neutral fed funds rate is an estimate only. The Fed publishes it with their other forecasts after their meetings. And it’s the first number that I look at. It was recently reduced to 2.375% after being at 2.5% for almost three years.
Bank of Canada, on the other hand, puts a neutral in the range between 2% and 3%, but likely closer to 3%. Terminal and neutral fed funds rates are critical indicators for judging when the sell-off in bonds went too far. When 10s (10-year yields) get toward what we think neutral fed funds rate will be, it’s time to at least buy back shorts. By the time they get to terminal level of fed funds, it’s definitely time to be long.
At the end of a hiking cycle, 10-year yields at levels above neutral fed funds don’t last long and historically have presented a bond-buying opportunity. These days, the fed fund peak is estimated to be above 3.5% within the next 12 months. And the market expects cuts in the year after that. We’re watching two-year yields (2s) as a quick way of determining if peak fed fund expectations are already priced in. As long as 2s keep going up, they are not. After their most recent disappointing CPI release in the U.S., 2-years headed north towards 3%, which very likely is close to that neutral fed funds rate.
Has the U.S. dollar peaked?
There’s been debate in the foreign exchange markets as to whether the U.S. dollar has peaked. And it’s been really interesting to see that debate play out in markets as currencies have fluctuated a little bit more meaningfully this year than they had in 2021. And for most of this year, the U.S. dollar has been strong. It’s benefitted from higher yields and has benefitted from a central bank that is expected to hike more times than many of its peers, especially those in Japan and in Europe.
In mid-May, however, a combination of things came together to weaken the dollar and really kick-started this debate about sustained U.S. dollar weakness. Among those were the fact that markets were starting to price in higher risks of a recession next year and, with that, a slower pace of rate hikes by the Fed, undermining yield support for the currency.
Second was that the euro started looking a little bit more attractive in the eyes of investors. It bounced from its 2017 lows after the ECB said that they themselves might hike interest rates as early as this summer.
And third was the situation in China. We had the Shanghai lockdowns being lifted. And I think that went a long way toward reducing some of the pessimism of China and reducing some of the investor preference for holding U.S. assets.
As we record this video in early June, the U.S. dollar has bounced again and is performing quite well. So it’s clear that this debate hasn’t yet been settled. But we think that we’re getting to the point where this yield gap between the U.S. and its peers is becoming excessive. And the U.S. dollar has reached the point where we would expect the U.S. dollar [to] weaken because it’s extremely overvalued.
So we think the U.S. dollar can soften materially over the next two to three years. But really until this short-term debate gets settled, we’re likely to remain in a very choppy and volatile currency market.
When it comes to individual currencies, we like the Canadian dollar. The Canadian economy is performing well. Interest rates in Canada remain high, even higher than those in the U.S. We’ve seen some very meaningful demand for Canadian assets by foreigners. And, of course, the currency is benefitting from higher commodity prices.
So we think the loonie can rally by another 6% toward an exchange rate of $1.19. That would be enough really to see the currency outperform its emerging market and developed market peers.