BNY Mellon: The Dollar and Policy Divergence

Oct 17, 2018

 By John Velis, FX and Macro Strategist, Americas, BNY Mellon

DXY is about 1.5% higher since September 26, after what has been seen as a hawkish FOMC.

The September 2018 Summary of Economic Projections (SEP) included a marginally higher terminal rate for Federal Funds and late-cycle dots that stay above neutral for a while before converging.

It’s unlikely that the minutes will alter current market pricing, given the on-message nature of Fed speakers since the meeting. Rate hikes will be gradual, the economy is growing nicely, the existence of the Phillips Curve is still a fundamental assumption behind policy-making deliberations – even if it hasn’t led to noticeable wage inflation yet, and policy will continue to be gradually tightened.

With the policy setting so clearly described, then, why hasn’t the dollar continued to grind higher?

To some degree, equity market volatility has penalized the USD and rewarded safe havens like CHF and JPY (up 3.4% and 1.5% respectively – if we consider their post-September 26 peaks).

Additionally, however, there is a strong argument that the policy divergence trade which has driven medium-term dollar movements for the last couple of years has peaked.

It’s not only that the dots continue to be more aggressive than comparable market pricing in the futures market: it’s that relative to the other major central banks, there just doesn’t seem to be that much more divergence to price in.

The chart below shows DXY against a weighted average of the expected policy differential of five of the six members of the DXY Index. (We eschew Switzerland owing to a lack of quality futures data).

For each central bank, we compare the furthest OIS (or money market future) for every trading today since the end of 2015 to the 1y1y forward rate (a rough proxy for the policy rate two years hence). The difference between this “expected policy path” for the Fed versus the other central banks is what we would call a policy divergence proxy.

It’s clear that broad dollar movements in this period have followed the policy divergence trade. It also appears that in recent months, the policy divergence proxy is flat. It’s not that the other central banks are likely to start raising rates, but rather the Fed’s path has been so well-advertised that there has been little upside.

Market perception of the Fed’s future actions has been pretty stable since this past summer. If anything, the dollar is at risk to a future de-rating of Fed expectations, causing the proxy to decline, bringing the buck down with it.