Fed rhetoric boosts the US dollar, but critical risks loom

The US dollar got back on the rally track recently, prompted in particular by a parade of US Federal Reserve speakers out last week warning the market that it is too complacent on the prospects for additional Fed rate hikes in what appeared to be a coordinated message. Two regional Fed presidents mentioned the prospects for two to three rate hikes by year end when the market was recently having a hard time even fully pricing in a single rate hike. The most pointed rhetoric came from influential New York Fed President William Dudley, who clearly indicated the Fed preference for a “summer” hike if the data continues to point to a US recovery. 

The market’s skepticism of further Fed rate hikes in the pipeline appeared thoroughly justified by the very dovish pivot in the Fed’s rhetoric at the March FOMC meeting. It was clear at the time that all of the market turmoil that marked the beginning of the year had thoroughly spooked the Fed, in particular the Chinese currency devaluation issue, combined with a steep dip in equity prices and credit market suggesting accelerating credit woes in the junk bond market. Of course, it was the Fed’s own dovish pivot that helped engineer the recovery in risk appetite since then.

So now the question for markets is two-fold. First, is the US economy sufficiently robust to warrant another couple of Fed rate hikes, particularly if we look at the political calendar? The next hike, at least, looks like a done deal in June or July if the US data merely heads sideways or better. Second, will global markets be able to withstand the global tightening implications of a strong US dollar or do we simply risk a repeat of the late 2015 and early 2016 environment, in which a stronger USD punished emerging market currencies and stocks, aggravated the Chinese devaluation issue and nearly led to a global equity bear market at the February lows?

One issue that can’t be lost on the Fed is the risk to the US economy from the most unusual presidential election cycle in modern memory. If we look across the pond to the UK and the uncertainty surrounding the UK referendum on June 23rd, it is clear that the uncertainty around this event may have fed a notably weakening in the UK economic momentum this year. In the US, could the US political situation offer a similar obstacle for business confidence? After all, some recent polls have shown the widely detested Donald Trump nonetheless able to edge out an increasingly struggling, and also widely disliked Hillary Clinton in November. 

And will Clinton even be the Democratic nominee? She remains the target of an FBI criminal investigation on the use of a personal e-mail server to conduct public business while she  served as Secretary of State and her hard-charging opponent Bernie Sanders may leverage his surging popularity to contest her nomination at the Democratic party convention in July, particularly if we wins the June 7 California Democratic primary. A Trump victory versus a Sanders victory – that’s a diverging pair of outcomes US voters and businesses can believe in. 

The Fed is in a very tricky spot, in other words, not only when it looks ahead at the US political calendar, but also when it looks around the world at the potential effects of its actions on the global economy, as it is the central banker of the global reserve currency. For now it is putting on its blinders and declaring total dependency on incoming US data. A very interesting and likely volatile second half of the year awaits markets as we navigate these issues and as the US dollar likely continues to strengthen for now.