After hearing from the Federal Reserve over the last few months, it seems inevitable that a rate hike is coming on December 16th. In the FX market, this is led to extreme dollar strength. The question on many people’s minds rightfully is whether or not this dollar move will continue higher. We have seen many correlated markets catch up to Fed rhetoric of late as they start to price and the first rate hike since 2006, now we can look to these markets to see whether or not the dollar will continue higher or whether all the bullishness is roughly baked in at the current price.
A Look around the (Financial) World
The fixed income market and most notably the front end of the US Treasury yield is nearly skyrocketed since October 15th. The 2-year US Treasury yield can be seen as a proxy for what the Federal Reserve is expected to do with interest rates over the next two years.
While a rate hike has been expected from the Federal Reserve before any other central bank in the world over the last year, the 2-yr US Treasury yield was only expecting one or two hikes of 25 basis points each a few months ago and is now expecting double that with the two years yield around 1%.
Another little known, yet very helpful market is that of Eurodollar futures. On October 15th, the Eurodollar futures contract took a decisive turn lower and are continuing to do so, which indicates further dollar strength. The Eurodollar is a futures contract traded between banks that effectively set USD-based lending interest rates in offshore accounts. In 2012, there were 425.1 million Eurodollar contracts traded to Crude Oil's 134 million.
As a reserve currency, this is very important. To read a chart of Eurodollar futures, it is helpful to note that the lower the chart goes, the more expensive money becomes when institutions lend money to each other unsecured. Eurodollar futures reference the 3M LIBOR, which is a benchmark in finance and is determined daily to determine what the premium is to lend.
As you can imagine, now that the odds are ranging between 66-72% that the Federal Reserve could hike their reference rate for the first time since 2006, banks are hedging their bets, but there could be more to the story.
Today is a 2-for-1 chart-special because it is helpful to explain what has happened when we've seen drops in the Eurodollar futures before. Because the 3M LIBOR represents the rate that banks would lend to each other on an unsecured basis for 3-months, a higher rate means tighter financial conditions and is shown when theEurodollar contracts price falls. The chart pattern that is shown in the first chart is a rising wedge, which can denote a sharp drop (rising interbank lending rate) in the market. The second chart shows the drop in Eurodollars in past crises followed by a large move higher as central banks rushed to provide QE to the world. This is not to call a crisis tomorrow, but to share with you that if the Eurodollar contract drops much further, the economy could get hurt, and equities market could fall even with central bank help. The FX outcome would presumably be USD & JPY strength.
Dollar Indices Are Sitting Near Multi-Year Highs Going Into December 3rd
December 3 is a very big day for the FX market. Read more here [Insert About Article]. Going into the first week of December, the USD is close to the highs, and the question now turns to what could stop the US dollars rise? The most obvious development that could stop the US dollar is an overoptimistic Federal Reserve changes their tone and communicates a slower rate path hike they currently anticipated. This will pull down the 2yr UST yield that shows a positive correlation to the US dollar in push-up Eurodollar futures which are inversely correlated to the US dollar strength.
Lastly, a more doubtful outcome that could bring about a dollar turn lower is if all the good expectations are baked in such that large investors start to cash in on their long dollar trade because the expected upside is now diminished. In this environment, the 2yr UST yield would either move sideways or a small variance from the current level as would Eurodollar futures, but when new buyers failed to show up, it does not take long for the sellers to start overpowering buyers.