US: One interest rate differential driving the USD - ING

The US dollar’s de-coupling with a spectrum of interest rate differentials of late has gained quite a bit of attention, according to Viraj Patel, Foreign Exchange Strategist at ING. However, there may still be one interest rate differential that matters for the broader trajectory of the US dollar – and that’s the relative neutral interest rate differential, he further adds.

Key Quotes

“With Fed Chair Jerome Powell testifying to Congress tomorrow, we expect to hear a lot of noise in the near-term over the Fed’s neutral interest rate – and a potential upgrade in light of greater optimism over the US and global economy. But even if we assume that occurs at the March FOMC meeting, there are two caveats to consider before concluding that this will lead to any broad US dollar strength: (1) whether the move higher in the US neutral interest rate estimate is specific to the US economy and (2) whether markets have already priced this in.”

“In this instance, we argue that any near-term optimism over higher US neutral interest rates will not translate into a higher US dollar – not least because much of the optimism of late is likely due to an upward revision in the global neutral interest rate. Exchange rates thrive on unpredictability and mispricings – and therefore monetary policy as a driver for currencies packs more punch in economies where the gap between actual policy rates and neutral interest rates is the biggest. With the Fed tightening cycle all but priced in, the focus is on the rest of the world – namely Europe and Japan – where there is greater scope for positive monetary policy adjustments to drive the respective currencies higher.”