Dollar Responds To Rising Rate Hike Probability

Although the latest revision to the second quarter gross domestic product figures received a nice upgrade from earlier estimates, the optimism comes secondary to the fact that US economic activity has decelerated to the slowest pace since the last financial crisis. This caution is widely reflected by recent comments from key Federal Reserve members touting their more dovish stance towards the outlook. However, the futures market does not seem convinced that a year-end rate hike is off the table despite the disappointing fundamental data.

With Fed Fund futures showing an increased probability of December action, the US dollar continues to ascend even amid a growing backdrop of risk factors that could derail further tightening. However, considering that monetary policy remains a one-way street at present, the dollar continues to reflect that the only way forward is upwards.

December Speculation Sends Dollar Surging

The Fed has unleashed its roster of “perma-doves” onto the newswires as evidenced by the last 48 hours filled with remarks from key policymakers. Besides Chairwoman Yellen’s constant reminders that there is no “fixed timetable” for rate hikes, she has also indicated that the inflation target is not necessarily the strongest indicator for the policy outlook. She stressed to Congressional members that the 2.00% inflation target is “not a ceiling,” indicating her comfort with letting inflation overshoot its target without taking preventative action to prevent it from overheating. Her comments were flanked by Minneapolis Fed President Neel Kashkari who recently the idea that no September action was the “right move.”It is increasingly obvious that the Fed wants to see a further improvement in fundamentals before hiking, evidenced by Atlanta Fed President Dennis Lockhart who wants to see a greater traction in economic activity before adjusting policy.

Despite the resounding dovishness of the Federal Reserve, there remains increasing hints that the economy is reaching its potential. For one, Yellen let slip during her testimony that the current pace of job creation could lead to an overheating of the economy. The clue indicates that another two strong job creation readings could rapidly reduce the obstinacy to a rate hike, increasing the importance of next week’s payroll figure.In the meantime, the upgraded 1.40% second quarter GDP figure has further raised the speculation that December action is more than probable. Fed Funds futures reflect this likelihood with December tightening odds rising to 52.00% on Thursday after dropping precipitously after the conclusion of the last Fed meeting.The reaction in the dollar has been palpable, with last week’s dip buyers rewarded for their confidence in policy normalization.Looking ahead, the US dollar will likely continue to benefit from these tailwinds.

Technically Speaking

Looking at the US dollar index on a longer-term basis, the consolidation of the better part of 2016 becomes evident. The symmetrical triangle formation is formed on the basis of a downward trending line above the price action from the December 2015 highs combined with the upward trend line beginning with the May lows. Based on the convergence of the two trend lines, the dollar basket is rapidly approaching a breakout that may materialize over the coming month. Although a monetary policy decision would be the likely catalyst behind heightened momentum and volatility that might be force a breakout, no such decision is anticipated before December. Even though the dollar has responded positively to heightened probability of a rate hike, it needs bearing in mind that the last rate hike was accompanied by a significant decline in the US dollar, raising the potential for a repeat.

While positive fundamentals may contribute to a technical breakout, other technical factors suggest that an upward bias may be misplaced. For one, the price action continues to trend below both the 50 and 200-day moving averages. Each of the moving averages is currently acting as resistance against any sustained rally in the Dollar Index as evidenced by multiple recent failures to overcome the levels on a daily chart. Even though there is still case for bullishness, especially with the more near-term ascending triangle setting up since August, it would require a clean break above the significant resistance sitting at 96.22-96.28 which neatly corresponds with the 200-day moving average. However, as narrowing volatility in the pair shows, a breakout move is approaching, and sooner or later is set to materialize, especially if accompanied by falling trading volumes which typically precede a major move.

Looking Ahead

Although optimism is tangible right now in the US dollar thanks to the better than anticipated data, as recent Fed commentary indicates, the Central Bank is on the fence about raising rates and continues to take a more dovish stance towards the outlook. Nevertheless, there are several developments that could force rate doves to reconsider, namely upcoming employment data due next week from the Bureau of Labor Statistics. Another strong job creation figure will likely contribute to further upside in December rate hike expectations. Furthermore, even though they do not seem to care if inflation overshoots, a continued climb might underscore the need for action soon rather than later. While the US dollar index may be showing some optimism in the outlook, based on historical reactions to rate hikes, it may yet be misplaced if a rate hike does transpire.