Will tapering do the trick for the dollar?

New York (Dec 17)  USD: recovery a long-time coming…The US dollar continued to weaken last week, with the DXY index pulling back briefly below 80. There was no significant reaction to the budget deal reached by the Republicans and Democrats – even though the agreement averts the risk of a government shutdown in 2014.

We believe this deal has heightened the probability that the Federal Reserve will start to taper quantitative easing this week. Yet the greenback’s response to economic indicators is diminishing. This raises several questions. For instance: has tapering already been priced into long-term interest rates and the US dollar? Does the market no longer want to be long on the greenback, due to the Fed’s previous u-turns? Or has the market already discounted a strengthening of forward guidance?

First, let’s look at the pricing debate. Long-term interest rates (the segment of the curve that will be most affected by any scaling back of central bank Treasury purchases) are already high, which suggests that tapering may already be priced into the market. In addition, the US 10-year rate still has an upside potential of 40 basis points to 3.20% over the next six months. Our view, however, is that the precise timing of tapering has still not been priced in. Rather, the market consensus seems to point to the Fed acting in January at the earliest, if not March.

Turning to forward guidance, the Fed could confirm that the Fed Funds rate will not be raised – even if the unemployment rate pulls back below 6.5%. If forward guidance is strengthened in this way, anticipation of an interest rate hike would be pushed back, leading to a flattening of the Fed Funds futures curve and, in turn, a correction of the US dollar.

A close eye should be kept on the Fed’s revised forecast for GDP growth, inflation and unemployment. The unemployment rate for 2014 – forecast back in September – is unlikely to change as the 6.4%-6.8% range is already quite low. This suggests that the 6.5% threshold could be reached as early as next year.

Against such a backdrop, the very near-term outlook for the US dollar is uncertain. If tapering starts this week (and therefore earlier than the market anticipates), the US dollar should strengthen, as tapering would indicated that the Fed is confident with regard to employment and growth. On the other hand, strengthening forward guidance could have the opposite effect and weaken the US dollar.

(Courtesy of Nordine Naam, Natixis)