INTRODUCTION

The dollar continues to strengthen, due in large part to the Fed’s undeniable steps towards tapering. Using the previous tapering episode as a roadmap, we see dollar strength persisting well into 2022 due to monetary policy divergences.

Dollar bears always have a long laundry list of reasons for long-term dollar weakness. Is it the burgeoning national debt? Twin deficits? A weakening US economic outlook? All of these (and perhaps more) likely contributed to the dollar’s swoon when the pandemic started. Being old-fashioned as we are, however, we believe that relative monetary policy stances are often the major driver of currency movements – at least in the near term. In the long-term, of course, real growth differentials will also be a major factor that is also reflected in interest rate differentials.

CENTRAL BANK DIVERGENCE

The Fed is widely expected to announce tapering at the November 2-3 FOMC meeting. Furthermore, Chair Powell has embraced an accelerated timeline for tapering that would see QE end by mid-2022. The Fed Funds futures strip has rate lift-off fully priced in for Q4 2022 followed by two hikes in 2023.

So far, the BOC, RBA, and BOE have tapered. Norges Bank and RBNZ have both started tightening cycles. BOC has signaled that it is likely to see lift-off in H2 2022, while recent statements from the BOE now has the short sterling strip pricing in three hikes in 2022. These relatively hawkish stances have led CAD (1.4% YTD), NOK (flat), GBP (-0.4%), and NZD (-3.4%) to be the best performing major currencies this year. But even then, only the Loonie has been able to gain against the greenback.

The other major central banks are firmly in the dovish camp. The ECB is likely to extend PEPP in some fashion beyond March, and its latest macro forecasts suggest no lift-off until 2024 at the earliest. Similarly, the most recent BOJ forecasts suggest no lift-off until FY24 at the earliest. The SNB also shows no inclination to tighten before 2024. The Riksbank may be the most dovish central bank anywhere, as its projected rate path is flat through Q4 2024. These relatively dovish stances have led JPY (-7.5% YTD), SEK (-6.3%), EUR (-5.4%), AUD (-4.9%), and CHF (-4.6%) to be the worst performing major currencies this year.

DOLLAR OUTLOOK

The dollar continues to power higher to new highs for this year. DXY recently made new highs for this year near 94.50 and the September 2020 high near 94.742 is the next target. After that, there are really no major chart points until the June 2020 high near 97.802. The euro traded at the lowest level since July 2020 near $1.1530 and there are really no major chart points until the lows from June and July 2020 just below $1.12. Elsewhere, USD/JPY made new highs near 112.10 and is nearing the February 2020 high near 112.25 and then the April 2019 high near 112.40. As this pair moves higher, we have to start thinking about the October 2018 high near 114.55. Lastly, support for sterling held near $1.34 but we believe it remains on track to test the December 2020 low near $1.3135. After that is the November 2020 low near $1.2855.

Despite the Fed’s efforts to disentangle rate lift-off from tapering, the market isn’t biting. The U.S. 2-year yield is currently trading around 0.31%, more than double what it was in mid-June below 0.15%. Increases in the 2-year yield have coincided with periods of growing Fed hawkishness, and the U.S.-German differential is currently around 101 bp, the highest since late March 2020. With the ECB remaining in dovish mode, this differential should continue to rise. Indeed, with the ECB widely expected to extend QE after PEPP ends in March, there is a chance that the dollar’s gains go parabolic again in 2022. As the chart shows, it has been a major factor for the euro exchange rate. As it stands, our rates call lines up quite nicely with our dollar call.

A BRIEF HISTORY LESSON

The dollar typically does poorly at the onset of each round of QE. Here’s a recap of Fed policy changes and the dollar price action since the Great Financial Crisis. There are a few instances where the dollar moves counter-intuitively, but for the most part, the price action reflects major monetary policy changes. Lastly, just as loosening policy tends to weaken the dollar, removing accommodative policy tends to strengthen it.

November 25, 2008: In an intra-meeting move, the Fed started Quantitative Easing (QE). It announced plans to purchase a total of up to $100 bln of agency debt and $500 bln of agency mortgage-backed securities (MBS). DXY fell over 12% from November-December 2008

December 15-16, 2008 FOMC meeting: After the final 100 bp cut at this meeting, the Fed Funds rate hit the rock bottom range of 0-0.25%. DXY rose over 15% from December 2008-March 2009

March 17-18, 2009 FOMC meeting: QE was extended with another round of agency MBS purchases worth $750 bln and agency debt worth $100 bln. Most importantly, the Fed also announced it would buy $300 bln worth of longer-dated US Treasuries over the next six months “to help improve conditions in private credit markets.” DXY fell more than 17% from March to November 2009

November 2-3, 2010 FOMC meeting: QE2 began. The Fed announced that it would purchase $600 bln of longer dated treasuries at a rate of $75 bln per month though Q2 2011. DXY fell nearly 11% from December 2010 to May 2011

September 20-21, 2011 FOMC meeting: Operation Twist was announced at the meeting. This plan initially called for the Fed to purchase $400 bln of US Treasuries with remaining maturities of 6 to 30 years and to sell an equal amount of US Treasuries with remaining maturities of 3 years or less. These purchases would last through June 2012 and extended the average maturity of the Fed's portfolio. DXY fell more than 6% in October 2011

June 19-20, 2012 FOMC meeting: The Fed extended Operation Twist through year-end, noting that “This continuation of the maturity extension program should put downward pressure on longer-term interest rates and help to make broader financial conditions more accommodative.” DXY fell nearly 3% in October 2011

September 12-13, 2012 FOMC meeting: QE3 was introduced. This new round of quantitative easing introduced an open-ended commitment to purchase agency mortgage-backed securities at a pace of $40 bln per month on top of the extended Operation Twist program. DXY rose nearly 4% from September-November 2012

December 11-12, 2012 FOMC meeting: QE3 was amended with the Fed purchasing an additional $45 bln per month of longer-term US Treasuries. DXY rose over 2% from December 2012-January 2013

On the other hand, the dollar tends to perform well when the Fed’s extraordinary stimulus measures are unwound. After having boosted QE3 at the last meeting of 2012, Fed officials were already discussing tapering at the first meeting of 2013. Discussions continued at every subsequent meeting. With some fits and starts, punctuated by the Taper Tantrum, the Fed took steps to prepare the markets for tapering. DXY rose over 7% from January to July 2013

December 17-18, 2013 FOMC meeting: The Fed finally reduced its monthly pace of both UST and MBS purchases by $5 bln each to $40 bln and $35, respectively. Tapering continued at this pace over each successive meeting until QE ended October 2014, nearly a year after it began. At this point, the Fed kept the size of the balance sheet steady by reinvesting any maturing proceeds. Of note, the dollar’s gains became parabolic after mid-2014 and this was largely due to changes on the other side of the coin as the ECB began its QE operations. DXY rose nearly 25% from July 2014-March 2015

The Fed tightening cycle did not begin until December 2015. Then, the Fed delivered the first hike since June 2006 with a 25 bp move. DXY fell nearly 9% from December 2015-May 2016 but then rose 13% to peak near 104 in January 2017

Rate hikes continued. There was only one hike to follow in 2016, also at the December meeting. In 2017, there were three 25 bp hikes in March, June, and December. DXY fell over 12% from January-September 2017

In October 2017, the Fed started to shrink its balance sheet by letting maturing debt run off. Previously, the Fed had reinvested maturing debt back into new paper. The balance sheet shrunk at an average of $32 bln per month until August 2019, bringing the overall size down from $4.46 trln to $3.76 trln. DXY fell nearly 7%% from October 2017-February 2018

The Fed continued to normalize policy. In 2018, there were four 25 bp hikes in March, June, September, and December. DXY rose nearly 11% from February-December 2018

The Fed was eventually forced to make a so-called mid-cycle adjustment. In 2019, there were three 25 bp cuts in July, September, and October. DXY rose nearly 4% from July-October 2019

Growing turmoil in the repo markets over the summer of 2019 signaled that the balance shrinkage had likely gone too far. In September 2019, the Fed began asset purchases again but took pains to emphasize that this was not QE. Instead, it was presented as a technical move meant to maintain a deep pool of excess reserves so that repo markets could behave normally again. DXY fell over 3% from September 2019-January 2020

As a result of the pandemic, the Fed cut rates quickly in early 2020 and then announced open-ended asset purchases on March 23 2020. It’s not a coincidence that the dollar peaked the previous Friday, with DXY putting in a cyclical top near 103. DXY fell over 13% over the rest of 2020 before bottoming in January 2021

The dollar rallied in Q1 2021 but then retested the lows in Q2 2021. By mid-year, it was clear that the Fed would soon start planning an exit strategy from its emergency measures. We got the first hint of this at the June FOMC. Not coincidentally, DXY bottomed in late May and has since risen over 5%