Something special happened last week: the Fed funds rate rose to 66bps.
Why is this important? Historically, / dx depends on not only the direction of US yields, but also the absolute level.
A "high yielder" can be defined as a currency whose offers at least the third highest yield in the G10. By this definition, USD is now officially a high yielder.
The last time this happened for more than a few months in 1979 and 1997, the dollar rallied by 30% and 20% respectively.
Looking at long-end yields too, UST 10Y yields are now at least the third highest across the 5, 10 and 30Y tenors. The dollar is a true high yielder.
With the US labour market operating close to full capacity and growth running above trend, one would expect wage pressures to rise in 2017 (thus leading to an acceleration in CPI ). Against this backdrop, the Fed is in a good position to start hiking at a decent rate.
Near-term upside risks
- Since any potential fiscal boost from the Trump administration is still v uncertain, it is yet to be incorporated into the FOMC's economic outlook, as only "some" members included it in their projections. Therefore, it would be sensible to anticipate further $ strength owing to pricing of a steeper path for the fed funds rate in 2017 (currently, fed funds are only pricing in 55bp of hikes in the year to come).
- FOMC seems to be less concerned about the effect of a higher USD than in the past (neither the Fed statement, Yellen's testimony nor the Q&A made any mention of the greenback despite its recent surge), most likely because recent moves have not been accompanied by higher or a sharp move lower in commod prices (held up by Trump's proposed infrastructure plans). This is a factor that constrained the Fed in the past from accelerating its normalisation pace.
- Yellen seemed to take a step back from her comments about running a "high pressure" economy at the most recent meeting. Although Chair Yellen emphasised the fact that the dot plot revision was very moderate, she did not stress her intent to normalise gradually as much as in the past.
Based on previous price action, I expect / dx to reach the highs of 2002 as a conservative estimate.
The FX compass is pointing North, do not be on the wrong side of it!
Good luck and have a Merry Christmas!