The dollar and interest rates have been exhibiting unstable movements recently. Multiple factors contribute to this volatility, and understanding these elements is crucial for navigating the current financial landscape. Let's delve into the key reasons behind this instability and explore potential future scenarios.
Seasonal Patterns: Repeating Cycles of Volatility
One factor to consider is the seasonal effect observed in financial markets. Historically, October has often been a month of heightened volatility for both the dollar and interest rates.
In October 2022, The Federal Reserve's prolonged tightening policy fueled expectations of higher rates for longer, pushing the U.S. 10-year Treasury yield to touch 5.0%. Concurrently, an extreme weakening of the yen contributed to the dollar's strength.
Similarly, in October of the previous year, despite expectations, interest rates saw a considerable increase.
This pattern suggests that the tightening cycles initiated since 2022 might be creating mini-cycles of their own, influencing market movements in specific months.
Potential Federal Reserve Pivot in November
Interestingly, both in 2022 and 2023, by November, expectations for a Federal Reserve pivot began to emerge. This led to a sharp decline in both interest rates and the dollar.
If this pattern repeats, the November Federal Open Market Committee (FOMC) meeting could surprise markets with a dovish turn. Possible actions include an unexpected rate cut, considerations to end Quantitative Tightening (QT), or a shift in the Treasury's issuance strategy favoring short-term over long-term bonds.
Federal Reserve Chair Jerome Powell might also signal that the war against inflation has been won and express increased concerns about an economic downturn.
However, it's important to temper expectations. While seasonal patterns exist, the likelihood of the Federal Reserve making sudden policy changes in the upcoming FOMC meeting is relatively low.
Inflation Concerns: A Reawakening Threat
Another significant factor is the renewed concern over inflation.
If the rate cuts in September were a misstep that overly stimulated asset prices and consumer spending, there's a risk of inflation resurging. A revival of inflation would be a substantial burden for the Federal Reserve, potentially undermining the progress made in combating rising prices.
Notably, the U.S. 10-year Treasury yield has spiked recently, and the 2-year yield has also increased significantly. This suggests that the market is growing wary of the Federal Reserve's stance and the possibility of further tightening.
The cyclical pattern of inflation prompting rate hikes, which then leads to recession fears and subsequent pivot expectations, appears to be in motion again. When pivot expectations boost asset prices and spending, it can reignite inflation, bringing the cycle full circle.
It's important to recognize that inflation may not be a battle that's fully won. Since March 2021, inflation has consistently exceeded the Federal Reserve's target for three and a half years. The public has grown somewhat accustomed to higher inflation, increasing the risk of inflation becoming entrenched.
The "Trump Trade": Market Reactions to Political Developments
A third factor influencing markets is the so-called "Trump Trade".
With the possibility of Donald Trump's return to political prominence, markets are reacting based on historical precedents. The general perception is that a Trump victory leads to rising stock prices, interest rates, and a stronger dollar.
After Trump's election victory on November 9, 2016, U.S. stock markets surged, and interest rates spiked sharply.
At that time, the major concern was prolonged economic stagnation and the strengthening deflationary pressures. Trump's policies, which included massive fiscal spending and increased tariffs, sparked expectations of an inflationary trade. His America First approach led to a robust U.S. stock market, rising inflation expectations, and an influx of investment capital into the U.S., all of which contributed to a stronger dollar.
However, if the current market movements are driven solely by the Trump Trade, the sharp appreciation of the dollar may face a sudden turning point.
Historical Perspective: Dollar Strength and Subsequent Weakness
While the dollar showed significant strength until the end of 2016, the trend reversed in 2017.
Throughout 2017, the dollar weakened substantially, continuing until the end of January 2018. This period of dollar weakness benefited not only U.S. stocks but also emerging market equities, which saw considerable gains.
Interestingly, this occurred even as the Federal Reserve conducted three rate hikes in 2017. Despite higher interest rates, the dollar continued to weaken, which is somewhat counterintuitive.
The dollar's decline halted at the Davos Forum in late January 2018. Then-U.S. Treasury Secretary Steven Mnuchin commented that a weaker dollar was good for the U.S. economy, which drew sharp criticism from global finance ministers and central bank governors. Even President Trump, who typically disregarded such criticisms, hastily clarified that the U.S. preferred a strong dollar.
Despite these efforts, the dollar's trajectory had already been set. The resumption of dollar strength from 2018 put pressure back on emerging markets.
Trade Wars and Currency Movements
From 2018 onwards, the U.S. initiated a trade war with China, imposing tariffs that unsettled emerging economies.
In response, China retaliated by significantly increasing tariffs on U.S. goods and devaluing the yuan, exacerbating tensions.
By August 2019, the yuan breached the 7 yuan per dollar threshold, signaling a willingness to allow further currency depreciation.
This escalation led Trump to shift from imposing tariffs to seeking trade negotiations in the latter half of 2019. The goal was to pressure China into purchasing more U.S. goods, culminating in the U.S.-China trade agreement at the end of 2019.
Trump's strategies to address the U.S. trade deficit alternated between promoting a weaker dollar, imposing tariffs, and compelling increased purchases of U.S. goods by trading partners.
This history suggests that while Trump may publicly advocate for a strong dollar, his primary focus has been on reducing the trade deficit, sometimes favoring a weaker dollar to achieve that goal.
Reevaluating the "Trump Equals Strong Dollar" Assumption
Given this context, the assumption that "Trump = Strong Dollar" may be overly simplistic and potentially risky.
While initial market reactions to a Trump victory might include a surge in the dollar and interest rates, long-term trends may differ.
Considering Trump's historical preference for policies that reduce the trade deficit—even if that means a weaker dollar—the current strong dollar trend could face a significant reversal.
Investors should be cautious in assuming that a Trump presidency will unilaterally lead to sustained dollar strength.
Conclusion: Navigating Uncertain Waters
The current instability in the dollar and interest rates is the result of a complex interplay of factors:
- Seasonal patterns that historically affect market movements in October and November.
- Renewed inflation concerns that could prompt the Federal Reserve to adjust its policy stance.
- The potential impact of the "Trump Trade", with its associated market perceptions and realities.
While historical patterns provide valuable insights, they do not guarantee future outcomes. The financial markets are inherently volatile and influenced by a multitude of variables.
As we approach the next FOMC meeting, it is crucial to monitor:
- The Federal Reserve's communications and any shifts in monetary policy.
- Ongoing inflation data and economic indicators.
- Political developments, particularly those related to U.S. leadership and trade policies.
Investors and market participants should remain vigilant, adopt a balanced perspective, and be prepared for sudden changes in market dynamics.