Analysis-Dollar’s rally may be nearing ‘tipping point’ as Fed readies

By Saqib Iqbal Ahmed and Gertrude Chavez-Dreyfuss

(Reuters) – A months-long rally in the dollar may be reaching its peak as the Federal Reserve gears up to deploy more interest rate hikes, according to the currency’s trading patterns in past tightening cycles.

The dollar has risen around 7% against a basket of currencies in the past year to its highest level since March 2020, boosted in part by expectations the Fed is ready to employ robust rate hikes to tame the worst inflation in nearly 40 years.

Those gains are largely consistent with the dollar’s behavior during the last four rate hike cycles, which has seen the U.S. currency climb an average of 2.2% in the 12 months before the central bank started raising interest rates.

Up, up and away for the dollar index https://fingfx.thomsonreuters.com/gfx/mkt/lgpdwgkrqvo/Pasted%20image%201650571129259.png

In three out of the last four hiking cycles, however, the dollar index went on to pare some of its gains, losing an average of 1.4% between the first and last rate increase, according to a Reuters analysis of Refinitiv data.

“It is entirely possible that the dollar overshoots on the high side, revisiting levels we saw eight-nine years ago, but we think we are getting pretty close to a tipping point,” said Lisa Shalett, chief investment officer at Morgan Stanley (NYSE:) Wealth Management.

Fed hiking regimes and the U.S. dollar https://graphics.reuters.com/USA-MARKETS/DOLLAR/myvmnyolmpr/chart.png

Analysts at Goldman Sachs (NYSE:) wrote that the current projections of Fed tightening are comparable to the central bank’s rate path in 1994-1995, when policymakers raised rates by 300 basis points for the steepest hiking cycle in decades. The Fed raised rates by 25 basis points in March and investors are projecting nearly 260 basis points of cumulative rate increases through next February.

While the dollar strengthened in the months prior to the first increase in 1994, it fell 8.4% by the time the Fed was through, as rate hikes by other global central banks closed the gap between U.S. yields and those in other currencies, Goldman’s analysts said in a recent report.

in rate hiking regimes https://fingfx.thomsonreuters.com/gfx/mkt/klvyklgwyvg/Pasted%20image%201650557417651.png

Although the gap between yields on U.S. debt and foreign government bonds has widened in recent weeks, that dynamic could change if other central banks grow more aggressive in monetary policy, or if U.S. data shows growth starting to slow.

“The moment the markets sniff properly that the Fed is done with their hawkishness amid the backdrop of slowing U.S. data, then the dollar will fall off and we can get back to looking at interest rate differentials,” said Richard Benson, co-chief investment officer at Millennium Global Investments.

Advantage dollar…