As we all know, the US economy is performing well to all accounts. And as such, the FOMC are going to be considering raising interest rates in the not-too-distant future. Right now, as I type, the futures market for the Federal funds rate sees the first hike at some date between Early June and September.

So that puts us roughly 9 months from the first rate hike from the Fed. The 1st in many, many years. Many junior traders and investment managers who started their career in 2007, have never seen a Fed hike - and these are the people who will now be managing directors or Portfolio managers at sizeable hedge funds. While looking at historical charts of how various assets respond to hikes is one thing, actually trading it is another. Typically a Fixed income manager will look to buy USD-denominated, short duration bonds during a hiking cycle, so as to protect themselves from the MTM impact of higher rates.

In FX, typically higher US rates act in multiple ways to benefit the USD;
  1. Higher interest rates serve to decrease (in theory) inflation, and as such, real interest rates rise leading to a high USD
  2. Higher interest rates lower the growth in money supply, with a relative decrease in supply, the USD rises
  3. A relatively higher interest rate increases the demand for the USD, hence leading to a rise in its value.

Above we can see the US federal funds rate, in effect, their base rate. We can identify, in our modern era, 4 major hiking cycles.

However when we look at ICE's US dollar index, we can see the start of hiking cycles don't necessarily lead to a stronger dollar, and neither does the USD rise in the run-up to the 1st hike (something we are certainly seeing today)

In fact, considering the 1994 hiking cycle, the start came at the very top, and the USD fell throughout the cycle, only to recover once the Fed stopped hiking. At first glance this seems very perculiar.

But this shows us the most important theme of the upcoming hiking cycle, the monetary policy divergence. Considering 1994, (using synthetic, secondary market rates) EUR interest rates where rising, as where most major economies.

What is most notable about this hiking cycle, unlike any other, is the insanse divergence in monetary policy between the two largest economies, the Eurozone and the US. In purple we see the 1 year interest rate 1 year forward for Europe, and white for the US.

Not only on interest rates, but in terms of extra stimulus, the ECB is planning on boosting the balance sheet by up to €1 trillion

So, in terms of trading the FX markets, the EURUSD is the obvious candidate, as the divergence is most prominent, however USDSEK and potentially even high yielders (AUD and NZD) are at risk.

But starting with the EURUSD, we've seen it drop quite a fair chunk in recent months, and while we note from CFTC (or wherever) that positioning is really short, we know that we are likely to look back in a years time and see the EURUSD much lower. We've seen a flurry of banks come out recomending selling the EUR here with y/e price targets below 1.25, some as low as 1.10.

Personally, I think that selling the EURUSD is a perfect trade, however timing it is going to be crucial. Sure, I think if we sell now, 6 months from now we will be profiting. But I do also think we will have better opportunities (above 1.30) with which to sell. I know 5 years is a long way away, but a 5 year forward outright currently trades at 1.41. Considering we may see a move lower towards 1.15/1.2 over the next year or two, harnessing the higher US yield (and steep curve) while selling the EUR seems attractive to me.

Regarding high yielders, we expect to see the belly of the US yield curve to rise, as well as higher volatility across the asset classes. Carry 101 suggests that these currencies are at risk, as such seeing 0.85 and 0.75 would hardly be surprising.

However the most important recommendation I would have is thinking about how we want to fund medium term trades, typically everyone jumps toward a USD denominated major pair. Instead, If I were planning on buying the GBP or NOK (or whatever) then look to use the EUR to sell, as the gradual move lower in the EUR over the coming years will be off benefit to this.

In conclusion, I expect that this hiking cycle is very different from those historically, given the wide range of differing central bank directions, and as such, we should not fight the central banks.

Thanks for reading.
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