FX International Payments
By Frances Coppola
At the end of 2016, many analysts forecast that the U.S. dollar exchange rate would strengthen significantly in 2017.1 In response to an improving economy and falling unemployment, the Fed was signaling interest rate rises, while other major central banks such as the European Central Bank and the Bank of Japan were maintaining negative interest rates and quantitative easing (QE). Economic theory suggested that a stronger outlook for the U.S. economy, coupled with an expectation of higher interest rate rises, would push up the dollar's exchange rate. Some wondered whether a strong dollar would depress economic growth.2
One year on, the U.S. economy is growing at about 3 percent per annum,3 and unemployment is the lowest it's been in 17 years.4 The Fed raised interest rates three times, most recently in December 2017, and is gradually reducing the size of its balance sheet, which has been inflated by QE asset purchases.5 But the dollar's trade-weighted exchange rate has proved much weaker than expected. Instead of rising, it fell steadily for the first nine months of the year, appeared to recover somewhat, then fell the final week of the year to end 2017 down 7.5 percent – its biggest annual decline since 2007.6,7
In part, the weak dollar reflects economic improvement in the EU and Japan. The prospect of future interest rate rises and the end of QE have encouraged investors to buy the euro and the yen at the expense of the dollar. As the euro and the yen rose against the dollar, carry trades became less profitable, as interest rate differentials between the major economies were squeezed by exchange rate rebalancing.8
But the dollar's weakness also reflects persistently low inflation in the United States, which calls into question the future path of interest rates.9 The Fed is still signaling continued interest rate rises, though some analysts now expect a slower pace of increase.10 The fact that the Fed's December decision was not unanimous lends support to those who think that interest rates could remain lower for longer.11
A flattening yield curve suggests the U.S. dollar exchange rate could remain weak well into 2018. The yield curve is the expected path of future interest rates, as expressed through yields on government bonds. The difference between yields on 2-year and 10-year U.S. Treasury bonds shrunk from 1.25 percent in January 2017 to 0.56 percent in December 2017.12
Neel Kashkari, president of the Minneapolis Federal Reserve, thinks that the Fed's interest-rate policy could be depressing yields on longer-dated bonds. "As the [Federal Open Market Committee] has raised rates, the front end of the curve is moving up with our policy moves, which is to be expected," he says. "But because the Committee has been raising rates in a low inflation environment, we are sending a hawkish signal, which is likely holding down the long end of the curve by depressing inflation expectations." An alternative explanation might be that the long-term natural rate of interest is lower than it was before the financial crisis.13
Kashkari says that a flattening yield curve could indicate increasing risk of a U.S. recession. "An inverted yield curve, where short rates are above long rates, is one of the best signals we have of elevated recession risk and has preceded every single recession in the past 50 years," he warns, and continues, "These signals should offer caution about future federal funds rate increases, unless inflation picks up."14
Economic theory says that currency exchange rates should respond more to short-term interest rates than to long-term, since increasing a short-term interest rate encourages investment inflows, which should in turn raise the currency exchange rate.
However, the strong forward guidance issued by central banks regarding the path of interest rates could mean that short-term rate increases are already priced into the exchange rate. Additionally, European and Japanese investors have been buying longer-dated U.S. Treasuries because of negative yields on longer-dated European and Japanese bonds. Currency exchange rates could therefore be responding more to long-term rates than short-term.15
Stubbornly low long-term rates and a flattening yield curve could therefore signal sustained U.S. dollar exchange rate weakness.
The exchange rate of the U.S. dollar has been surprisingly weak in 2017, given the U.S. economy's strong performance and the Fed's interest rate rises. It may be that currency exchange rates are responding more to long bond rates than short-term interest rates. Long bond rates remain low despite rising short-term rates. This is causing the U.S. yield curve to flatten, which may indicate increasing risk of a U.S. recession. Businesses planning FX hedging strategies may wish to keep an eye on yield-curve behavior.
With 17 years’ experience in the financial industry, Frances is a highly regarded writer and speaker on banking, finance and economics. She writes regularly for the Financial Times, Forbes and a range of financial industry publications. Her writing has featured in The Economist, the New York Times and the Wall Street Journal. She is a frequent commentator on TV, radio and online news media including the BBC and RT TV.
1. “Currency traders are having their worst year since 2006,” Wall Street Journal; https://blogs.wsj.com/moneybeat/2017/12/13/currency-traders-are-having-their-worst-year-since-2006/
2. “Does a strong dollar slow the growth rate of GDP?,” St. Louis Federal Reserve; https://www.stlouisfed.org/on-the-economy/2017/january/does-strong-dollar-slow-growth-rate-gdp
3. “US economy at a glance,” Bureau of Economic Analysis; https://www.bea.gov/newsreleases/glance.htm
4. “Civilian unemployment rate,” FRED Economic Data; https://fred.stlouisfed.org/series/UNRATE/
5. “Fed flags three more rate rises in 2018,” Financial Times; https://www.ft.com/content/1c93d6c8-e028-11e7-8f9f-de1c2175f5ce
6. “Trade-weighted US dollar index (major currencies),” FRED Economic Data; https://fred.stlouisfed.org/series/DTWEXM
7. “U.S. Dollar Ends With Biggest Annual Decline Since 2007,” Wall Street Journal; https://www.wsj.com/articles/u-s-dollar-falls-headed-toward-biggest-annual-decline-since-2007-1514578309
8. “Currency traders are having their worst year since 2006,” Ibid.
9. “Yellen describes low US inflation in 2017 as a ‘mystery’,” Financial Times; https://www.ft.com/content/de31f704-cf2c-11e7-9dbb-291a884dd8c6
10. “Fed flags three more rate rises in 2018,” Ibid.
11. “FOMC statement December 12-13,” Federal Reserve Board; https://www.federalreserve.gov/newsevents/pressreleases/monetary20171213a.htm
12. “The yield curve is flatter! Remind me why I care,” Bloomberg; https://www.bloomberg.com/news/articles/2017-12-11/the-yield-curve-is-flatter-remind-me-why-i-care-quicktake-q-a
13. “Why I dissented a third time,” Medium; https://medium.com/@neelkashkari/why-i-dissented-a-third-time-fccbdf0f16
15. “Forget the Fed: the long bond is deciding the US dollar’s future,” Wall Street Journal; https://www.wsj.com/articles/forget-the-fed-the-long-bond-is-deciding-the-dollars-future-1511198751