Flirt No More - The U.S. Dollar Breaks Down As Rate Hike Odds Move To 2016 Again

|
Includes: FORX, FXE, FXY, SPY, UDN, USDU, UUP
by: Duru

Summary

The U.S. dollar index breaks down in the wake of a massive equity sell-off and a repricing of odds for the first Fed rate hike.

Atlanta Fed President Lockhart has set up the Fed's excuse for capitulation on 2015, even as he insisted that a rate hike should come in 2015.

The euro and Japanese yen have been primary beneficiaries of the U.S. dollar's weakness and become prime targets to short against the U.S. dollar once the dust settles.

The downward momentum I noted earlier on the U.S. dollar (NYSEARCA:UUP) (UDB), followed through and delivered a breakdown. Those who thought the S&P 500's (NYSEARCA:SPY) problem was a strengthening dollar must really be longing for the good ol' days. Now, equity markets are falling right alongside the U.S. dollar.

The S&P 500 is already challenging the lows from the last oversold period in October 2014!

The U.S. dollar temporarily breaks its previous low since the downtrend from the March 12-year high.

The U.S. dollar index, at one time, traded at its lowest point since making a 12-year high back in March. Those days seem like another era now that the shine of policy divergence is slowly fading as a tailwind for the U.S. dollar. According to the CME Group FedWatch, the odds for a September rate cut are now sitting at 23.6%, lower than they were a month ago. The odds of a rate cut in December have fallen below 50%. These moves put 2016 back on the table as a very real possibility for the first Fed rate hike. Indeed, Barclays decided to break with the 2015 consensus in making the case for a March 2016 rate hike. From Reuters:

"'Although we continue to see economic activity in the U.S. as solid and justifying modest rate hikes, we believe the Federal Reserve is unlikely to begin a hiking cycle in this environment for fear that such a move may further destabilize markets,' Barclays' economists Michael Gapen and Rob Martin said in a research...

Should market conditions stabilize and prove transitory, Fed policy-makers could the end its near zero interest rate policy at their December meeting, they said.'"

While this research note seems to state the obvious, it is not so obvious, given the large group of steadfast pundits and analysts who are trying to stick to a September rate hike. Ultimately, an easy principle to apply here is the assumption that the Fed is loathe to do anything that has a perceptible chance of upsetting the markets and the real economy. The Fed has dragged out the whole discussion of hiking rates in the hope that the actual start of rate normalization would feel anti-climactic. As luck would have it, it has waited so long that the weakness in the global economy has caught up to its plans. A rate hike in this environment is far from anti-climactic, and will only serve to touch off a whole set of new anxieties.

Federal Reserve Bank of Atlanta President Dennis Lockhart attempted to put a good face on the Fed's frustrating dilemma. On August 24, 2015, Lockhart spoke in Berkeley, CA on "The Interplay of Public Pensions and the Broad Economy." During Q&A afterward, Lockhart of course had to field questions on the timing of rate hikes. He had, not long ago, insisted that September would mark an ideal time for starting normalization. The market has clearly sobered him up a bit. There was no mention of a September rate hike as Lockhart appealed to the "complexity" of the decision before the Fed (was it ever uncomplicated?). From Bloomberg:

"I expect the normalization of monetary policy - that is, interest rates - to begin sometime this year... Currently, developments such as the appreciation of the dollar, the devaluation of the Chinese currency, and the further decline of oil prices are complicating factors in predicting the pace of growth."

These references are clever ways to set up what I think will be the Federal Reserve's excuse for capitulating on a 2015 rate hike. The data have changed, and the Fed will say that in capitulating, it is simply doing what it would do all along: decide with the data.

The euro (NYSEARCA:FXE) and the Japanese yen (NYSE:FXY) are leading the way in pounding down the U.S. dollar as rate hike odds get repriced. Both currencies have their own serious flaws, such that the current fears of "policy reconvergence" will surely give way to deflation fears in both Europe and Japan from overly strong currencies. The economic recoveries in both regions are much more fragile than the one in the U.S., and I strongly suspect central bankers there will be eager to counter what they will see as counter-productive strengthening in their currencies. That charts below show how both currencies have accelerated in their moves against the U.S. dollar.

At one point during the market sell-off on Monday, August 24, 2015, the euro returned to a level last seen when the European Central Bank (ECB) announced a much-anticipated program of quantitative easing.

In the current market sell-off, the Japanese yen not only reversed the dollar's gains from the big breakout in May, but also it touched the low point of the year on USD/JPY.

(Charts Source: FreeStockCharts.com)

The Japanese yen was particularly overstretched. The rapid bounceback of USD/JPY from the lows of the year demonstrate how much the market had gotten ahead of itself.

These big moves have me more interested than ever in trading the dollar from the long side. The euro is my first target. I think an end to vacation time in Europe will bring a freshly motivated and active ECB to the scene that will want to put an end to deflationary forces from a rapidly strengthening currency. Anyone remember the ECB's decision to avoid QE operations during the low-liquidity period of the summer and to accelerate QE before and after?

As risk aversion grows in the market, I think the Japanese yen will still have more runway before it, too, becomes an ideal candidate to short again. Anyone buying the euro for "safety" (as opposed to covering carry trades) will be sorely disappointed by the reality on the ground. Stay tuned...

Be careful out there!

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: In forex, I am short the euro and net long the Japanese yen.