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Dollar: the big difference compared to the 2004-2006 cycle

The essential

The dollar has risen sharply since mid-2014, whereas it fell significantly during the previous fed funds tightening cycle (2004-2006). Could the divergence between monetary policy at the Fed and the other major central banks explain this?

Although it is undeniable that the divergence in monetary policy has clearly pushed the dollar up over recent quarters, it is much weaker than during the 2004- 2006 cycle. In reality, these two cycles are differentiated by the fact that commodities prices have been in sharp decline for some time, whereas they were rising significantly during the previous cycle.




Unless it pulls out a major surprise, the Fed will hike its fed funds rate on 16 December, after seven years of zero rates. It is only natural to ask ourselves what this will mean for the US dollar. In reality, as we have previously mentioned, the dollar has already risen sharply since the summer of 2014 (+15% in real effective terms), with the majority of market observers attributing this to the monetary policy divergence between the Fed on one side and almost all other developed market central banks on the other (see the graph linking the dollar with the gap in the Fed’s short-term rates compared to its main partners). However, the United States’ real effective exchange rate declined during the last major fed funds tightening cycle, in 2004-2006. The currency lost 7.6% between mid-2003 and the end of 2006 in effective terms.

During the 2004-2006 cycle also, the Fed’s rate policy was also different to that of its partners, to a much greater extent than today. Remember that as of the end of November, futures contracts were only pricing in an extremely slight increase in the Fed funds rate, barely 1.5% by the end of 2017. The divergence in monetary policy, which is measured by the difference in short rates, was much more marked during the 2004-2006 cycle. So, why did the US dollar decline so much during the 2004-2006 cycle? As is
often the case when trying to explain major monetary trends, we have to look in China’s direction.
In reality, the 2004-2006 cycle fell during a decade when China’s stellar growth still seemed to be unstoppable, and which led to a sharp rise in commodity prices (oil, metals) over several years. As such, a close negative correlation exists between the dollar’s exchange rate and commodity prices. Clearly, the correlation is not causal. Academic papers are struggling to agree on the direction of the causality between these two variables, which often leads to contradictory results. However, we can easily conceive that
the explosion in demand for commodities by China exacerbated the rise in prices, which could have had a negative impact on the US dollar.
For the US dollar, two major factors were working against each other during the 2004-2006 cycle: 1) divergence in monetary policy between the Fed and its trade partners (positive for the dollar) and 2) the rise in commodity prices (negative for the US dollar). The second factor won out and the dollar ultimately declined. In the current cycle, these two factors are having a positive impact on the US dollar, and it would appear to be for this reason that the US dollar rose so much, despite the relatively weak rise in the short-rate differential. Furthermore, we note that the two factors mentioned provide an excellent explanation of the trend in the real effective exchange rate in the United States since the beginning of the 2000s.
What can we deduce from this for the coming quarters? Firstly, it is unlikely that the increase in the Fed funds rate on 16 December will radically change the game in terms of the short-rate differential (US short rates have clearly not waited for the fed funds rate to actually be increased before rising): it is likely to widen a little but, since we believe that the fed funds tightening cycle will be of limited scale, this widening will also be curbed. Then, in light of the economic slowdown in China, we can imagine that commodity prices (metals in particular) will be able to find a slightly lower equilibrium. But there again, commodity prices have already declined substantially and it is hard to see how this downturn can continue for very much longer. In sum, the US dollar is expected to appreciate further, but its appreciation potential has already been massively eroded.



The divergence in monetary policy, which is measured by the difference in short rates, was much more marked during the 2004-2006 cycle




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DRUT Bastien , Fixed Income and FX Strategy
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Dollar: the big difference compared to the 2004-2006 cycle
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