The Fed confirmed global central banks’ dovish pivot last week, as it cut rates for the first time since 2008, albeit by less than some market participants had foreseen. Its moderate easing stance was in line with our expectations—and we see easier global monetary policies stretching the current cycle and supporting risk assets. This buys investors time to fortify portfolios even amid a further spike in U.S.-China trade tensions.
A narrowing interest rate differential between the U.S. and other countries would usually point to a weaker dollar. Yet the dollar has been surprisingly resilient in 2019. We see key reasons why. First, other global central banks are in easing mode too, so rate differentials have not moved as much against the dollar as headline changes in Fed expectations would have suggested. Second, rising macro uncertainty is leading to a “safe-haven” bid for the dollar. Our research suggests the trade-weighted dollar is currently around 3% higher than we would expect based on its historical relationship with rate differentials alone. Yet it is tracking where we would expect, after accounting for risk appetite and economic uncertainty. See the chart above. Third, we believe markets may still be overestimating the scope for further Fed easing.
Ongoing dollar crosscurrents ahead
Evidence is strengthening for the dovish pivot in global monetary policy that we previewed in our recent Global investment outlook. The Fed cut rates by a quarter percentage point last week but appeared less committed to further rate cuts than some market participants had expected. The European Central Bank and Bank of Japan both stayed on hold in July, but the former confirmed it’s planning a package of stimulus as soon as September and the latter said it would not hesitate to ease further if warranted. Chinese leaders also used mildly more dovish language in communication out of a Politburo meeting on the economy last week.
This renewed easing stance by global central banks is a reflection of rising global macro risks and, in some cases, persistent below-target inflation. In our view, protectionism is stoking greater macro uncertainty, widening the range of potential economic and market outcomes ahead. This led us to downgrade our global growth outlook in early July. Trade disputes and broader geopolitical frictions are now the key drivers for the global economy and markets. This was underscored by a fresh U.S. threat last week of a 10% tariff on $300 billion of Chinese imports starting September 1. U.S.-China tensions are likely to be structural and persistent, according to our Geopolitical risk dashboard. The prospect for elevated macro uncertainty suggests the bid for the U.S. dollar is likely to last. Conversely, if macro uncertainty were to ease and risk appetite returned to normal levels, the dollar could weaken. What are the other risks to the dollar outlook? The Fed cutting more than we expect or the U.S. administration taking steps to weaken the dollar could weigh on the U.S. currency.
Fed policy will be a key driver for markets, including exchange rates. We see the Fed lowering rates further but find market expectations of 0.75 percentage point in cuts by the end of 2020 as excessive, given what we see as limited near-term risk of recession. On balance, we do not foresee a disruptive strengthening in the dollar. This supports our overweight on emerging market (EM) debt, driven by attractive income and appreciation potential in some local EM currencies.