By Jamie McGeever
ORLANDO, Fla. (Reuters) – The dollar has been hit hard by aggressive repricing of U.S. interest rate expectations but it is likely too early to write off the greenback.
The dollar is currently at its weakest level this year against a basket of major and emerging market currencies, which raises the question: Can this downward momentum continue?
If we look at it through the lens of relative interest rates, the answer is a resounding “no.” In fact, the depth and speed of the Fed’s easing, now factored into the U.S. futures curve, appear overstated, both in absolute terms and especially in relative terms.
Traders now expect the Fed to cut interest rates by more than 200 basis points by September 2025, with the federal funds rate reaching its so-called final level of just over 3.00% the following year.
This assumes that the Fed will comfortably continue the most aggressive monetary easing campaign among the G7 nations.
Traders are also pricing in a very slim chance that the Fed will start its easing cycle with a 50 basis point rate cut next month. In recent Fed history, such a large initial cut has only been made in emergencies and crises.
There is no doubt that US markets have just suffered a massive volatility shock, and the large downward revisions to employment growth suggest that the labor market is creaking. So markets may be more fragile than previously thought.
But it may take more than a modest slowdown to justify the scope of easing that traders are now expecting.
Everything is relative
As the saying goes, if the US sneezes, the rest of the world catches a cold. But interest rate traders seem to assume that the rest of the world has acquired some immunity to US weakness.
While other major central banks such as the Bank of Canada, the Bank of England and the European Central Bank have already begun to cut interest rates, their expected rate paths are shallower than the Fed’s. In some cases, they have been significantly shallower.
The Bank of Canada is expected to cut rates by another 180 basis points, the European Central Bank by 165 basis points, the Bank of England by 135 basis points, the Reserve Bank of Australia by 100 basis points, and the Swiss National Bank by 60 basis points, based on key interest rates and implied final interest rates.
If these assumptions are indeed reflected in the dollar price, further dollar weakness will require the US economic outlook to become even bleaker, and for this shadow to somehow fail to spread to other countries and currencies.
As George Saravelos, head of foreign exchange research at Deutsche Bank, points out, the US economy continues to grow at a decent pace compared to its main rivals: the eurozone is flirting with recession, and China is flirting with deflation.
“We see the US easing cycle as much shallower than expected,” Saravelos said. “The risks seem to be tilted toward a more hawkish Fed.”
keep reality
A look at annual inflation rates across the G7 suggests that the central banks’ 2.00% target is within reach. But while the Fed may be allowing itself a well-deserved pat on the back, inflation in the United States is higher than any other G7 economy, by some measures.
But this could still limit the scope and speed of monetary policy easing, thus lifting the dollar off its lows in 2024.
It’s true that “real” interest rates in the US are high and have plenty of room to fall as growth slows. Adjusted for annual consumer price inflation, the real federal funds rate is near 3.00%, its highest level since 2007.
Stephen Jen of asset manager Euryzon SLJ is among many analysts who believe that historically high real interest rates will allow the Fed to continue its monetary easing program. In that case, the current dollar weakness is justified.
“There will come a time where the market will again over-pricing very significantly very soon, but my expectation is that we are not there yet,” Jane says.
But even if we agree that today’s expected path of rate cuts is likely to materialize, this is already calculated. It is hard to imagine that we will see further rate easing, barring a real crisis.
Again, we have to ask what will happen elsewhere. Real interest rates in other countries are at their highest levels since the global financial crisis. True, many are below the US rate, but some, like the Bank of England’s “real” rate, are on par.
Predicting currency movements can be like flipping a coin, as former Federal Reserve Chairman Alan Greenspan once observed, so we should exercise some humility when doing so. But it’s safe to assume that if the Fed cuts rates at a slower pace than expected, the dollar will rebound and fight back.
(The views expressed here are those of the author, a Reuters columnist.)