Is the dollar priced for Fed hikes?

The US dollar (USD) has strengthened over 15% on a trade-weighted basis since endJune 2014. But, a decomposition of USD moves into days dominated by a Fed shock and those by a growth shock suggests otherwise. Instead, most of the dollar's recent move is due to "growth shocks," likely related to slowing Chinese growth and/or ECB QE, not shifting Fed policy expectations. This suggests the USD has further upside once the Fed begins its normalization.

This contrasts with the 1994, 1999, 2004 tightening cycles when the dollar strengthened 3 months into the first hike before depreciating in the 3 months after as other central banks followed the Fed.

"With the exception of the BoE, we see most G10 central banks on hold or easing further through end-2016, most notably an expansion of ECB QE beyond 2016, further pushing USD-positive policy divergence," commented BofAML.

With Fed Funds futures implying a 35% chance of a September hike, the USD will rally in a hike scenario. But, outside of market expectations, the immediate reaction of the dollar to Fed hikes will be a function of several factors:

• Pace of hikes: The FOMC has socialized the idea of rate increases for well over a year. So, the communicated and actual pace of hikes after the first one is more important for the USD than timing per se. A faster pace on both would signal that the Fed is confidence about the economy and its ability to weather higher rates. There's upside potential here given the slow pace the market prices (relative to our own and SEP forecasts, see Chart 2), but significant USD strength could also slow the pace of hikes, evidenced by Fed official concern about USD strength. 
• Risk sentiment: Historically, equities have been mixed but come under modest pressure post-Fed hikes. A significant risk off could challenge USD strength given its positive equity correlation, mostly against currencies in countries with low interest rates like the Euro Area. 
• China: Should China's central bank allow its currency to weaken significantly this could lower inflation expectations in the US and spark fear about competitive devaluation likely slowing Fed hikes. But, this could also give China room to ease policy further and perhaps do QE, mitigating downside global risk for the Fed. 

Given the cross-currents of Fed hikes and continued Renminbi weakness, commodity sensitive currencies for countries like Australia, New Zealand and Canada offer the best potential as the Fed hikes.

"We also expect continued weakening of the Euro as the ECB will expand its QE program, likely later this year," added BofAML.