Next year's Fed hikes are mispriced, says RBC Capital Markets

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The dollar will continue to drive currency movements in G10, as markets are underpricing where the US central bank sees interest rates reaching neutral levels, which means the greenback has further strengthening on the horizon, says Adam Cole, chief currency strategist at RBC Capital Markets.

Neutral rates are the US central bank’s description for interest rate levels that neither boost nor restrict economic growth. In early October, Federal Reserve chairman Jerome Powell said rates were still a long way away from being neutral, despite three hikes this year, which pushed the Fed funds rate to 2.25%.

While market expectations are for US rates to plateau at the new neutral rate of 2.5%, RBC Capital Markets sees the central bank revising up its view of where the neutral rate actually lies.

“Most of the market moves in EUR/USD in recent weeks have been driven by the dollar side, rather than the euro,” says Cole. “It’s a picture driven by dollar strength.” 

He believes the Fed will hike interest rates four times in 2019, to bring US rates closer to 3%, and that it may even continue hiking well into 2020.    

“The biggest mispricing is the degree to which the Fed keeps hiking next year,” says Cole. “The concept of neutral is in itself extremely fluid and uncertain.”

The Fed is chasing a moving target between its own estimate of where neutral is while trying to push rates up towards neutral

Adam Cole, RBC Capital Markets

“The Fed is chasing a moving target between its own estimate of where neutral is while trying to push rates up towards neutral,” Cole says.

He does not expect any wild gyrations in EUR/USD over the coming year and sees the pair trading at 1.13 in a year’s time – the same as at the time of going to press.

However, RBC Capital Markets, which topped FX Week’s one-month forecast table last week, believes the market is underestimating the Fed’s willingness to continue hiking rates.

“We see US growth at trend or higher next year. As long as spare capacity is taken out of the economy, there is no signal for the Fed to stop hiking,” says Cole.

This means that for now, the dollar looks likely to continue as the driving force of FX moves, despite concerns about Italy in Europe. Italian bond spreads widened substantially against their German counterparts in recent weeks, but Cole says markets have already priced in the worst-case scenario.

“We’re likely to see cosmetic changes to the Italian budget to make it look like they are converging towards Europe, but actually doing very little,” says Cole.

“The reality is that Italy will deliver a loose fiscal policy beyond what it can afford. As widening spreads show, the market knows that,” he adds.