'Peak Dollar' Some Way Off: Natwest Markets

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- Arguments the Dollar will fall are premature

- It won't peak as long as the Fed is raising interest rates

- Other factors include trade tensions and ECB

The U.S. mid-terms are being digested and the overall impact on the U.S. Dollar appears rather marginal as the outcome of a split Congress is what markets were expecting.

Typically, it is only the unexpected that shifts currency markets in any meaningful manner in the short-term. We therefore expect recent trends and drivers to remain in place for the Dollar over coming days and weeks.

Expect the analyst debate as to when the Dollar will top out to continue.

Analyst Sayed Mansur Mohi-Uddin, head of FX strategy at Natwest Markets, says the Dollar won't peak until certain criteria are met, the first of which is the U.S. Federal Reserve completing its interest rate raising regime. 

"I think the markets will have to look at the Dollar peeking at some stage. I don't think we are there at the moment. I still think there are a few things we need to get out of the way before we see the Dollar peak. The first is the end of the Fed cycle," Says Mohi-Uddin in an interview on Bloomberg TV.

Interest rates are a key driver of FX because they determine capital flows. Rising interest rates tend to attract and keep more foreign capital because of the higher returns on offer. Falling or lower rates tend to have the opposite effect and weaken a currency.

The view that the Dollar outlook is tethered to the Fed is shared by Sankalp Soni, an analyst for Seeking Alpha, who also thinks the Dollar will continue rising for as long as the Fed continues raising interest rates.

"I believe it is still too risky to short the Dollar, as the Fed is likely to become more hawkish after the strong economic data, which will continue to support the USD higher," says Soni.

The end of the Fed's cycle is forecast to occur when the central bank has reached, or marginally surpassed, its 'neutral rate' which is the base interest rate at which the economy is said to be in 'equilibrium', neither growing or contracting.

This rate has been estimated to be at around 3.0% (Fed funds rate) by the Fed itself. This is still three 0.25% rate hikes away from the current  2.25% level.

Given the Fed is expecting to raise rates 3 or 4 times in 2019, it will probably reach 'neutral', and therefore the end of the cycle and 'peak' Dollar, by the end of the year.

The immediate implications of the call for the Pound-to-Dollar exchange rate is that any Brexit-triggered rally in the currency might struggle to reach its true potential in the face of Dollar strength. Indeed, if markets are sanguine about any Brexit deal the Pound could actually struggle to gain at all in the face of a continuation of the Dollar bullrun.

We can report that consensus estimates for GBP/USD have been raised for the 3, 6 and 12 month timelines. We recommend downloading the November exchange rate forecast report from Horizon Currency to see where over 50 of the world's leading investment banks and financial institutions are expecting GBP/USD to trade through 2019.

Secondary Factors

The Fed reaching the end of its cycle is not the only factor, according to Natwest's Mohi-Uddin, the end of the trade war between Washington and Beijing is another important hurdle which needs to be vaulted before the Dollar can be said to have peaked.

Improving trade relations has been US Dollar-negative thus so far, so a final deal would appear to be Dollar-negative and signal a peak as suggested by Mohi-Uddin continuing the current trend.

This appears to be because an easing in trade tensions has supported the outlook for the Remnimbi as well as other Asia-pacific currencies such as the Aussie and New Zealand Dollar, and assuming a continued negative correlation between the Dollar and risk sentiment, the U.S. Dollar could well peak as the trade war ends - assuming it does in fact end.

Yet there are those who say the opposite could happen and the Dollar could rise if Xi and Trump shake hands.

They argue the end of a trade war would remove a risk to the US economy and therefore encourage the Fed to hike rates even more aggressively leading to an even stronger Dollar. The trade war has come to be seen as a risk factor, not a driver of economic growth.

"In fact, a possible trade solution between the US and China would only add to the list of reasons for the Fed to stay on its hawkish path, which will keep pushing the Dollar higher," says Seeking Alpha's Soni.

How the ongoing trade war between the US and China will affect the Dollar, therefore, seems to be open to debate, and may depend on timing.

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'Peak Dollar' Could Rest with the European Central Bank

The Euro-to-US Dollar exchange rate is the largest contributor to the Dollar index, and so the timing of the European Central Bank's (ECB) first interest rate hike, currently forecast for September 2019, is also an important criterion for an analysis of when the Dollar may peak.

The recent run of negative data from the Eurozone has brought into question the timing of the ECB's first hike, which some say could now be delayed. The ECB, however, has continued to repeat its message that "underlying inflation" is on the rise and the current bout of weakness is only temporary.

Much depends on the evolution of Eurozone growth and inflation in the next few months but if the economy deteriorates further, the ECB could start to delay its withdrawal of stimulus, and probably the eventual date when it will actually raise interest rates.

Finally, whether the Dollar has peaked or not will probably also depend on whether emerging markets (EM) can make a come back, since one of the main reasons the Dollar has outperformed other currencies in 2018 is that economists were wrong in expecting growth between the US and the rest of the world to 'synchronise' in 2018, when in actual fact it diverged even more widely.

"Peak Dollar will occur but it is probably a few months or even a few quarters away," says  Mohi-Uddin.

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Bank-beating GBP/USD exchange rates: Get up to 5% more foreign exchange by using a specialist provider to get closer to the real market rate and avoid the gaping spreads charged by your bank when providing currency. Learn more here