A rate cut cycle in the U.S. and FX realignments

With the disclaimer that the collective wisdom of the world’s most sophisticated investors has been appalling at predicting where monetary policy in the U.S. is heading, the pundit consensus foresees an interest rate cut cycle starting at the upcoming meeting of the Federal Open Market Committee (FOMC), on 17-18 September1. According to calculations compiled by the Chicago Mercantile Exchange’s Fed Watch tool in late August, futures markets priced in a probability of 63% of a 0.25 percentage-point reduction in the Fed funds rate. But there is more. After the first move, the authorities would lower it by a further 0.50 percentage-point on the 6-7 November FOMC meeting (probability of 77%) and by another 0.25 percentage-point cut on 17-18 December (identical likelihood).??

To be sure, since the pandemic crisis markets have greatly underestimated the Fed’s willingness to raise rates and later consistently overestimated how quickly it would start cutting them. However, there are now very probable reasons to believe that they will have it right. Most decisively, because the U.S. economy is at last telling a consistent disinflation story (Chart I). For the first time since March 2021, the rate of headline consumer inflation on a year-over-year basis is below 3%. The much-scrutinized core PCE (Personal Consumption Expenditures) index is not yet at the comfortable 2% p.a. threshold - its latest reading showed an increase of 2.5% - but it seems to be landing there shortly. In the end, America is a case of a nation that decided to run a relatively large fiscal deficit for longer to boost economic activity through higher domestic absorption, which led to a tighter labor market and stronger wage gains (Chart II). A “soft landing”, it turns out, requires more time to tame the general price index. Germany, on the other hand, opted for conventional stabilization policies. Slower real GDP growth combined with smaller budget imbalances achieved faster and better results in containing the rising cost of living.??

The world’s largest economy starting to cut interest rates is always a pivotal moment. For the first time in this century, the Federal Reserve would switch to easing without the backdrop of panicked markets, which was a grim reality in the early 2000s (the burst of the dot-com bubble), in late 2007 (the global financial crisis), and during the second half of 2019 (COVID-19). Among the varied consequences of a less restrictive stance on monetary policy in the U.S., perhaps one of the most intriguing is the effect on the value of the dollar versus other currencies. The classic theory of interest parity and exchange rates posits that a decrease in the domestic to foreign short-term interest differential, all else constant, correlates with depreciation of the domestic currency. Conversely, an increase in the interest differential, all else constant, correlates with appreciation. The theoretical models and their developments based on these assumptions are quite elegant, yet for decades there was an empirical paradox because their forecasting accuracy was rather poor. Exchange rates, after a fleeting period of compliance with predictions, seemed to follow no discernible patter or trend (they were a “random walk” in the econometric jargon). But that was then.??

According to recent research, the prediction power of exchange rate models has improved noticeably2. The gradual commitment of major world economies to non-discretionary monetary policy, notably inflation targeting, resulted in more stable patterns in the 2000s compared to the previous three decades. Therefore, econometric regressions using interest rate differentials, inflation expectations, measures of global financial stress and estimates of the deviation from the estimated long-term real foreign exchange equilibrium, among other explanatory variables, now do a good job in terms of predicting the movements of America’s currency. In this context, the U.S. dollar experienced three major cycles of appreciation since 1971, when the Bretton Woods regime of pegged foreign exchange collapsed (Chart III). To understand why it is in overvaluation territory since 2015, it suffices to say that the Fed funds rate is at a 23-year high, whilst there is still a degree of risk aversion in global capital markets owing to geopolitical disturbances.?

Assessing the four main explanatory variables in the improved foreign exchange models cited above, three of them signal FX depreciation in America in response to a monetary easing cycle. Assuming no change in global risk aversion, the domestic to foreign short-term interest differential will trend lower, together with (hopefully) inflation expectations, which should foretell additional rate cuts ahead and additional weakening of the U.S. dollar. Furthermore, because the latter has deviated substantially from its estimated fair valuation, it is ripe for a downward correction. And an opportune timing that would be. Indeed, looking at how currencies of G20 countries are trading, for instance, it becomes evident that at least half of them are far from their long-term equilibrium levels in either direction (Chart IV). Having less unbalanced foreign exchanges signifies not only fewer overvalued exchange rates, but also fewer ones that are severely undervalued as well.??

In some cases, country-specific situations may speed up the realignment process. In Brazil, a large fiscal deficit and fast-rising labor costs are causing consumer inflation to drift away from the 3% p.a. target. Consequently, the Brazilian central bank will likely hike the policy rate to slow the economy, whose annualized real growth pace in the second quarter of 2024 was red-hot: 5.7%. In precisely the opposite direction of the U.S., futures markets are rather reasonably pricing in a cycle of monetary tightening in Latin America’s largest economy, of about 100 bps over the next 12 months. For the undervalued real, that spells revaluation. However, as Rudiger Dornbusch, an economist famed for his contributions to International Monetary Economics, wisely cautioned “Things take longer to happen than you think they will, and then they happen faster than you thought they could”.?

1 See, for instance, the revealing “hairy chart” in “Investors may be getting the Federal Reserve wrong, again”. https://www.economist.com/finance-and-economics/2024/01/24/investors-may-be-getting-the-federal-reserve-wrong-again#. The Economist, dated 24-Jan-24.?

2 Engel, C., & Wu, S. P. (2024). “Exchange Rate Models are Better than You Think, and Why They Didn't Work in the Old Days”. National Bureau of Economic Research WP32808, August.?

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