US Dollar Forecast 2016: A Year of Two Halves

Analysts at two major research institutions see a strengthening dollar in the first half of 2016 ultimately forcing the US central bank to pause their interest rate raising journey in the middle of 2016.

Deutsche Bank, forecast 75bps of hikes before the middle of next year, at which point the strong dollar and higher rates will start impacting negatively on the inflationary outlook, leading to a change in stance by the central bank, which could stall further hikes in response to the more doveish data: 

“Our economists believe the Fed will hike rates by 75bps by the middle of 2016 – and then pause of the rest of the year.” Says the research note from Deutsche. 

It suggests the dollar continuing to appreciate in the first half of 2016, and possibly peaking around the middle of the year, when the change in the Fed's tack may start to reverse the trend.  

In fact, Deutsche see the Dollar Index rising even more bullishly perhaps, increasing by 8.0% by the end of 2016:

“Our FX Strategists see about 8.0% upside for the U.S dollar trade-weighted-index (TWI) and 9.0% downside for the euro (TWI).”

BNP Paribas also see change in the summer

BNP Paribas’s Chief Rates Strategist, Laurence Mutkin, also sees the Fed taking a pause mid-year as a result of the back-wash effect of higher dollar and rates:

In a recent interview with Bloomberg, he said that he also saw the Fed pausing in the middle of the year:

“Our central case is that they (the Fed) probably don’t get to do four (rate hikes) next year, probably sometime in the middle of the year the rising dollar and interest rates will start to impact on the economy, which will start to show signs of slowdown, and they might ‘skip’ somewhere in the second half of next year.”

Fed’s dot plot indicates 100 bps of hikes in 2016

Holding such a view poses a problem when compared to what Fed members see happening in 2016.

The summer pause hypothesis contradicts Fed member's own perception based on its dot plot diagram, which indicates a likely 100bps of hikes in 2016. 

Given there are only four FOMC’s which come with a press conference in 2016, and that Yellen will probably want to use the pressers as an opportunity to announce further 25bps hikes, it would seem likely that that would equal a rise per conference; however, this would see a consistent rises throughout the year, rather than a pause mid-year.

Market-based indicators still favour shallow trajectory

Market-based indicators have been pricing in a more subdued pace of tightening than that suggested by the Fed’s dot-plot based on fears the strengthening dollar could weigh on inflation, and slowly erode motivation for continued rises:

“U.S. forward rates have remained out of whack with Fed dot plot and street rate path forecasts as persistent dollar strength clouds growth and inflation outlook in an over-extended credit cycle,” according to Bloomberg strategist Tanvir Sandhu. 

He argues: “The yawning gap, between forwards pricing and the dot plot as well as economists’ forecasts, may narrow as the rise in greenback, increasing volatility and higher yields have tightened financial conditions, preempting any need for an aggressive rate path.”

Dollar historically weak following first rate hike

Westpac’s Daniel Franulovich expects the dollar to weaken following the rate hike, based on its historical reaction to previous rate hike cycles:

“The USD of course tends to trade on the back-foot following the commencement of a hike cycle – falling in 4 out of the last 5 cycles,”

However, these cycles were predominantly in an era before the euro, which is now the heaviest weighted currency in the dollar index basket, as they happened in ’86. ’94 ’99 and ‘04.

Much, therefore, depends on the reaction of the euro and whether the nascent recovery in the euro-area takes root and really starts to move up a gear in the first half of 2016.

With many market analysts seeing at least a steady recovery growth track in the euro-zone, and given recent relatively strong data, including a 0.1% inflationary rise above expectations in November, it’s not impossible the same first-hike-dollar-weakness 'effect' will once again surprise markets.