FX Market View #26 Interest rates and risk drive Dollar higher

During the past month the Dollar has been trending higher against the majors, on the back growing investor sentiment towards FOMC rhetoric supporting a rate hike later this year. The Fed will not be the first central bank of a high income country to raise rates, as Norway lead the way last month. Second place goes to New Zealand with a likely rate hike from the RBN later in October. Therefore, it is no surprise that the Norwegian Kroner was the best performing major currency against the Dollar this month, before the Canadian Dollar took top position by the end of last week. Both the Canadian and Australian central banks have already begun tapering the stimulus programs. Primarily, the market correlates a strong currency with potentially higher interest rates.

Another factor that needs to be considered when analysing the recent strengthening Dollar pattern, is the level of risk tolerance investors are willing to endure. There appears to be clear interaction between the movements in the equity and bond markets, and how they have an impact on the Dollar. Fiscal and monetary policies of late have encouraged investors to drive a stock market rally, which now appears to be over extended. As a consequence, the recent rounds of profit-taking had paired some gains with investors turning towards the Dollar in times of uncertainty. Economic growth rates in the US and Europe have moderated as the rate of stimulus policies decreases. Supply chains have been disrupted with consumers feeling the negative impact to rising prices.

Entering into the last quarter of the year the Dollar lost some of its steam. The momentum that was gained, particularly over the last FOMC meeting has dissipated. However, this situation can be interpreted as the Dollar consolidating recent gains and not a shift in the overall trend. A possible scenario is the market waiting for the release of the NFP data later this week before evaluating the near term strength to support an extended Dollar rally. As it now stands, the employment numbers have to be reported significantly lower than anticipated before the Fed could consider delaying it tapering plans. Other than rising unemployment, the only other factor that could scupper a rate hike later this year if the US debt ceiling needs addressing.