The highly anticipated US employment data for the month of October released last Friday has sufficiently jolted market participants, busting the greenback from its shackles and elevating it against the majors. The greatest number of jobs added since December of last year, average earnings reaching new cyclical highs on a year-over-year basis, and the U6 Unemployment rate dropping below 10% for the first time since May of 2008, all reinforce the divergence meme investors had been beginning to question. While US domestic data has contributed to the resurgence of monetary policy divergence narrative, it is not the sole perpetrator for the greenback’s strength in a currency landscape that is exhibiting heightened volatility. Downgraded inflation and GDP forecasts for 2016 from the Bank of England has trimmed the value of the pound as expectations of a rate hike in 2016 are shaken; dovish commentary from European Central Bank chief Mario Draghi has lifted the prospects of more accommodative monetary policy from the central bank, with the next meeting on December 3rd looming like an ominous black cloud and pressuring the euro lower. Therefore, even though market participants are coming around to the fact that a December rate hike from the Fed is the most likely scenario, the shifting tectonic plates of monetary policy overseas are also contributing to the investment climate conducive to be long the big dollar.
While the pendulum has indeed swung back in favour of the monetary policy chasm between the US and the rest of the developed world widening at a quicker pace, we would caution the speed at which markets are currently expecting this to take place. Even though we have been in the camp that suggested a December rate hike was the most likely outcome since the Chinese equity meltdown shook markets earlier in the year, lift-off for the Federal Reserve and the speed of monetary policy divergence are two different beasts. Assuming a rate hike from the Fed does materialize in December, market participants will quickly resort to deciphering how the Fed defines a gradual normalization of monetary policy, and how that takes shape. Like the dot plots from the Fed that have constantly undershot inflation expectations, the estimation of interest rate levels is likely too ambitious, and policy normalization will probably follow a more gradual course than many on the FOMC currently anticipate. In addition, the Fed also has a robust balance sheet which it can utilize to drive monetary policy outside of the benchmark rate, and simply deciding to stop, or slow, the reinvestment from the proceeds of maturing securities could be used to influence policy while keeping interest rates low.
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