In Brief

• The Federal Reserve has been shifting its stance over recent months in response to a labour market showing signs of reaching ‘full’ employment along with uncomfortably high levels of inflation.
  
  
• The recent suggestion of adding balance sheet reduction to the policy mix has come earlier than many in the market had anticipated.
  
  
• The implications of balance sheet reduction for the dollar are nuanced, with the ultimate impact likely to depend on the resilience of equity markets, the shape of the treasury curve, the broader backdrop of global growth trends and policy decisions taken by other central banks.
  
  
• It is possible the Fed’s discomfort with easy financial conditions reflects some signs of unsustainably high growth and pockets of market exuberance. Over a longer time horizon this raises questions around a peak in the dollar akin to the dynamics around the turn of the millennium.

The Federal Reserve (Fed) has been shifting its stance in recent months, encouraging the market to bring forward the expected timing of rate hikes and ending quantitative easing (QE) earlier than previously planned. Economic data remains constructive, particularly within the labour market. The unemployment rate has continued to fall as jobs growth momentum has remained strong and those that left the labour force during the initial Covid outbreak have shown little sign of returning. While high levels of inflation had initially appeared to be temporary as energy and auto related components surged, evidence has mounted that price pressures may persist for longer than anticipated. The rise in housing related inflation in particular has historically tended to be persistent, and with signs of tight labour markets and upwards pressure on wages, the balance of risks to inflation no longer appears to be towards the downside.

Minutes from the Fed’s recent meeting suggested that a reduction in the central bank’s balance sheet is under consideration earlier in the tightening cycle than anticipated. The market’s view on the sequencing of policy was based around the concept that balance sheet tightening is a riskier tool to use, due to limited experience in calibrating the impact of balance sheet reduction and the weakness in risk assets seen during the only prior example of balance sheet reduction in 2018. The clearest motivation for such a change would appear to be some concerns around the transmission of gradual rate hikes to the economy in light of very accommodative financial conditions despite the rise in front end rates.

The historic link between currencies and central bank balance sheet sizes is variable (Exhibit 1); we do not believe the relative size of central bank balance sheets in isolation provide a useful mechanical signal for exchange rates. There are a number of factors we believe to be important when considering how the dollar responds should the Fed begin balance sheet reduction later this year. 

Exhibit 1 – 2018 balance sheet tightening impact on equity and dollar performance

Source: Bloomberg, data as at January 2022. Index: September 2017=100

The most important consideration for financial markets overall is whether risk assets fall as a result of balance sheet tightening. The prior example of 2018 suggests that a sustained period of rate hikes and balance sheet reduction poses some downside risks for risk assets and it is plausible the policy mix is chosen to target a tighter overall level of financial conditions. However, this must be balanced by the positive global growth and earnings outlook, and large accumulated savings that continue to stoke demand for higher returning financial assets. If balance sheet reduction did lead to sustained weakness in risk assets, from a currency perspective, the dollar is likely to mirror historical patterns (Exhibit 2) by performing better against more cyclical, commodity exposed currencies and faring less well against the low yielding safe haven currencies.

Exhibit 2: Currencies betas to US rates and equities

Source Bloomberg, data as at January 2022. Beta of weekly changes over last 10 years.

There is a question whether balance sheet reduction could act as a substitute for rate hikes and lead to a steeper yield curve with high longer term yields. This could result in financial conditions tightening more through equity underperformance as long term discount rates rise rather than through short term interest rates. From a currency perspective, this could provide moderate support to the dollar against higher beta currencies while seeing it underperform more policy rate sensitive, low yielding currencies.

It is important to also consider the composition of balance sheet tightening and the impact on the broader liquidity backdrop. With the Fed currently absorbing a significant quantity of excess liquidity via reverse repos it is possible that a smaller but longer duration balance sheet could have little overall effect on broader markets.

A broader move to prioritise balance sheet tightening by foreign central banks, such as the European Central Bank and Bank of Japan, could reduce some of the global demand for long duration assets that have been keeping rates curves so flat despite the rise in growth and inflation. Again, the implications here would seem clearest for the relative performance of safe haven and risky currencies, with the performance of each group against the dollar potentially diverging.

Exhibit 3: Deteriorating US current account and high US dollar valuation 

Source: Bloomberg, data as at January 2022.

Finally, it is worth considering whether the longer term outlook for the dollar is more vulnerable than the strong cyclical outlook in the US may initially suggest. There are some signs that growth in the US could be too strong, such as the recent deterioration in the balance of payments. Rising wages amid the slow return of workers who left the labour force suggests the labour market may also be closer to capacity constraints. With the dollar already expensive on long term valuation measures, such as purchasing power parity, there are some parallels to the peak in the dollar in the early 2000s (Exhibit 3), where US growth and rising rates proved insufficient to support the currency once poor fundamentals became the focus.

Bringing this all together, we see scope for modest dollar outperformance, particularly against the risk sensitive commodity bloc currencies in the near term as the market focuses on the more hawkish Fed policy stance. However, with the conditions developing for a topping out of the longer term dollar cycle, we remain watchful for opportunities to establish new dollar shorts against currencies with central banks whose policy stance are also turning in a more currency supportive direction and where underlying currency fundamentals are more favourable.