As expected the US Federal Reserve increased the policy rate by 25bps the day before and kept its future policy rate path unchanged – with one more hike in December 2018 and three more in 2019. Fed’s policy action was already priced in and therefore did little to significantly push up the dollar index. However, comments by the Fed chair yesterday that the US does not face a large chance of recession and the Fed plans to keep gradually increasing rates raised the dollar index above the 95 level today.
The Fed did not comment on the dollar’s value – which barring the last few weeks has had a good run this year. The dollar as measured by the DXY has rallied by over 6% since February, driven by strong US growth (at 4% in the second quarter), the safe haven trade and high interest rate differentials. This has led to the view that the dollar is overvalued and a correction is in the offing.
In our opinion, when and how the dollar rally turns is likely to be an important factor in driving currency markets over the coming months. To put this in perspective, the movement in the dollar index could be an important determinant of the trajectory of EM currencies, like the INR, over the next 6-8 months. So where is the dollar headed?
We think that while in the near term dollar strength is unlikely to abate significantly, we could see the dollar rally reverse as we get closer to 2019. However, the bulk of the correction in the dollar could (going by current trends) come against the DM currencies such as the Euro and the GBP and less against the emerging markets. While we are more sanguine about the gain in DM currencies against the dollar, the extent of the recovery in the EMs remains uncertain. Some EM currencies have fallen sharply in recent months and as a pack are undervalued. This warrants some appreciation against the dollar. However, given the continued rotation of funds away from the EMs, the extent of the recovery in EM currencies remains unclear.