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Why is the US dollar close to its peak?

There is a strong inverse relationship between the trade-weighted USD and oil prices. In order to investigate it in details, we distinguished five recent periods of sharp rise or fall of oil prices.

 

Period 1: 01/01/2007 – 30/06/2008   (oil prices +135%)  (trade-weighted USD -10%)

Period 2: 01/07/2008 – 31/12/2008   (-74%) (trade-weighted USD +13%)

Period 3: 01/01/2009 – 30/09/2009   (81%)  (trade-weighted USD -5%)

Period 4: 01/09/2010 – 29/04/2011   (67%)   (trade-weighted USD -9%)

Period 5: 30/06/2014  – 26/02/2016  (-70%)  (trade-weighted USD +22%)

 

As monetary policy and in particular monetary policy divergence is also an important driver of exchange rates, we also computed a policy rate differential between the US and the 26 countries in the Fed’s currency basket (it is complicated to find proper and homogenous proxies of monetary policy expectations for the 26 countries). Policy rates are weighted according to weights in the Fed’s currency basket. 

These charts allow us to make several remarks:

  • Be it a coincidence or not,large swings of oil prices often coincide with periods of increased divergence (in one way or another) of monetary policy between the Fed and its counterparts.This makes the analysis more difficult. During the periods 1 and 4, oil prices rose rapidly and the differential of policy rates also declined.  On the contrary, during the period 3, oil prices were up but the differential of policy rates increased also, making the trend of the USD unclear.
  • Despite the surge of oil prices during the 18 months between early 2007 and mid-2008 (+135%), the trade-weighted USD was down only by  10%. But during this period (period n°1), the rate policy between the Fed and its counterparts diverged greatly (the Fed becoming relatively more dovish than its counterparts), thus limiting the appreciation of the USD.
  • While all the planet is emphasizing the “monetary policy divergence”, the current policy rate divergence between the Fed and its counterparts is actually extremely limited (period n°5). On February 26, Lael Brainard (member of the Board of Governors) even made a speech entitled “What happened to the Great divergence?”… The current USD rally is probably far more linked to commodity prices than to the divergence of monetary policy. The trade-weighted USD only lost some % in January whereas markets stopped expecting any rate hike in 2016/2017. But of course, here, we’re only considering policy rates and not QE policies.
  • It seems clear that the trade-weighted USD is mostly linked to two variables: commodity prices (and in particular oil prices) and the difference of monetary policy between the Fed and its counterparts. Considering that oil prices at close to a bottom (any rise in 2016 would be slow, small or possibly erratic) and the divergence of monetary policy will be very slow, the trade-weighted USD is currently close to its peak or already reached its peak in January. This is crucial for the FOMC policy in the coming quarters as the USD strengthening since mid-2014 had a strong negative impact on inflation and growth and prevent the Fed from starting its fed funds tightening cycle earlier.

 

 

Brent prices
Nominal trade
Policy rate
DRUT Bastien , Fixed Income and FX Strategy
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