Dan Mitchell, Senior Portfolio Manager, provides his take on de-dollarization and how it will impact global currencies.
Dagmara Fijalkowski, Head of Global Fixed Income & Currencies, shares her thoughts on whether the U.S. Federal Reserve Board (Fed) is finished raising rates.
Watch time: 6 minutes 32 seconds
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Is the Fed finished raising rates?
Bond yields are higher this quarter. The Fed is expected to pause and then resume hikes. So let's review things that we know for sure. One, inflation has been falling, but at a pace that falls short of optimistic expectations from early this year. It says it is still too far above the target for the Fed to know that its job is done.
Jobless claims are rising, but very slowly, and unemployment is still steadily below 4%. So because of these two developments, one more hike is priced in, and we think justifiably so. Putting the terminal Fed funds rate at about 5.5%. Which means that in 2023, we would have about 100 basis points of hikes compared to about 400 that we experienced in 2022.
So absolutely, we still can say that the Fed is closer to the end of the hiking cycle than the beginning. We have been considering four key scenarios in recent months when it comes to development in the macro space, inflation, and bond markets. Let's update these probabilities. The good news is that the scenario with the biggest downside, both short term and long term, has declined in odds.
It was the scenario resembling the late 1970s when the Fed declared victory too early, only to see inflation later reigniting. And it would mean that the Fed's assumptions of neutral rate were too low, and policy has simply not been restrictive enough. More hikes would be needed, after the fact becomes clear and obvious to the Fed. Our confidence is that this scenario now has much lower probability, perhaps 10%.
The Fed is laser-focused on its credibility. The second scenario, the so-called “immaculate disinflation scenario”, also has lower odds now. Inflation has not been coming down faster than expected. Terminal fed funds rate expectations have moved higher. So that leaves us with two other key scenarios. One of them, we call it the “broken windshield scenario”, where the Fed would be forced to cut aggressively to preserve stability of markets and reduce systemic risk.
It appears that the Fed has been so far successful differentiating between monetary policy and macroprudential tools. Macroprudential tools are consistent with the Fed being the lender of last resort or market maker of last resort. And now, three months after Silicon Valley Bank, it seems these concerns are subsiding. Which leaves us with the last scenario. This is the only scenario where its probability is growing, and that's the “long pause scenario”.
So one more hike and then holding rates steady to allow for the monetary transmission to show results over time. This may or may not accompany a recession. We think that probably it will. With the “long pause scenario” being the highest probability scenario now, higher yields on bonds should be here to stay.
The 3.5-4% range that has been dominant on U.S. 10s since September last year may only gradually shift lower towards 3.5% over the next six months.
What is de-dollarization and how will it impact global currencies?
The term “de-dollarization” has become quite popular in media and in markets, and it's helped spark a wave of negative sentiment toward the greenback ever since the dollar peaked last October. We've seen this in the rally of the euro from $0.95 up to $1.10, and the strength of emerging market currencies, of Bitcoin and of gold also. This theme of de-dollarization is broad.
It captures a gradual move away from the U.S. dollar for the purposes of global investment and global trade. For investment, we've seen countries really look beyond the U.S. dollar as they try to diversify their giant pool of foreign exchange reserves. Two decades ago, when the European bond market was created, the euro really became a viable alternative for that purpose.
And China is pushing very hard to get the renminbi added to that list of global reserve currencies. In trade, we've also seen countries start to look beyond the U.S. dollar, avoiding U.S. payment systems and trying to execute trade in their own currencies. Brazil and Argentina, for example, are working together to export and import in their own currencies, and Saudi has started to accept other currencies for the oil that it exports.
Now this theme has become so pervasive that investors are really trying to question now whether the U.S. dollar really deserves to be the primary reserve currency of the world, especially given recent events around the debt ceiling debates, high fiscal deficits, and bank failures in the United States. In reality though, this is a very long-term theme. It's not something that plays out in weeks or months or even years.
This stuff takes decades to play out. So while we've incorporated this in our outlook for a lower U.S. dollar over the next couple of years, it's really just one of many factors that we consider in the outlook. We expect that most emerging market and developed market currencies will benefit in an environment where the dollar falls.