December 2, 2015 / 3:14 PM / 5 years ago

If history is a guide, dollar will drop after Fed hike

LONDON (Reuters) - History is not on the dollar’s side. In the last couple of decades, the dollar index .DXY, which measures the greenback against a basket of six currencies, has fallen every time the Federal Reserve has begun a cycle of interest rate hikes.

A woman is reflected on the glass as he walks in front of a board showing the Real-U.S. dollar and several foreign currencies exchange rates in Rio de Janeiro, Brazil, September 22, 2015. REUTERS/Sergio Moraes

This Graphic shows the change in the dollar index before and after rate increases:

The Fed likely to hike on Dec. 16 for the first time in almost a decade and many big banks, including Goldman Sachs and Morgan Stanley, think the dollar uptrend that began in the second half of 2014 remains intact.

Speculators are holding huge bets in its favor, given the U.S. economy is outperforming its peers and the Fed is the only major central bank set to raise rates. On Thursday, the European Central Bank is likely to lower rates deeper into negative territory and expand its asset purchase program.

A Reuters poll published on Wednesday showed 40 of 60 strategists pointed to more dollar upside in the coming year. [EUR/POLL]

But there is a view emerging that the divergence trade, which reflects the contrast between the Fed’s tightening policy and the easing stance of the European Central Bank and the Bank of Japan and which has bolstered the dollar against the euro and the yen, is probably in its final stages. [ID:nL8N13P1A0]

“Once the events in December are out of the way and the market realizes that the Fed will move only gradually, we could see the general bullish dollar environment begin to show its age,” said Ned Rumpeltin, European head of FX strategy at TD Securities.

After a likely quarter percentage point move this month, the interest rate market is pricing in 50 basis points of rate hikes in 2016 while the Fed’s forecasts suggest four rate hikes over the year.

“Going forward, if rates move a little higher than expected then the dollar will go up a little. However, if at any time next year the market thinks the Fed may need to loosen in 2017, then the dollar will plummet. The risk/reward in 2016 is for a weaker dollar,” said David Bloom, strategist at HSBC

In the past, the Fed has hiked rates when the global economy has also been performing at a steady clip. But this time around, there are concerns about a global slowdown, and how much appreciation in the dollar, the Fed policymakers will tolerate.

“We think that after a 10 percent trade-weight appreciation this year, we’re headed into the realm of a slightly weaker dollar,” said Simon Smiles, chief investment officer for ultra-high net worth at UBS Wealth Management.

“Not necessarily over the next month or two, but as we progress through the year, we see the dollar weakening to 1.10 against the euro, as the economic recovery in the euro zone continues, and a very modest pace of interest rate rises starts to pan out in the U.S.”

Additional reporting by Alistair Smout, graphic by Vincent Flasseur; Editing by Toby Chopra

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