Dollar's Historical Performance Raises Questions About Tightening Cycle

Markets are widely expecting the Federal Reserve to begin a tightening cycle when it meets on Wednesday, but history suggests that this may not necessarily lead to dollar strength.

In fact, the US dollar has behaved very differently across various Fed tightening cycles, with some instances showing significant weakness even as front-end yields continued to rise.

One of the most relevant historical comparisons is the 1994 cycle, when the Fed began an aggressive tightening cycle from a level much closer to neutral than in recent years. In this instance, the dollar weakened materially even as the bond market was being 'belted', showing that higher rates alone were not enough to support it.

Looking at the current market environment, while the US 2-year Treasury yield has risen into the expected hike, the dollar's performance has been unusually weak relative to history. This has led some analysts to caution against assuming a tight correlation between front-end yields and DXY, as correlations can vary significantly over time.

Despite these concerns, the technical picture for the dollar is showing signs of improvement, with Monday's rise in energy prices helping drag Treasury yields and the dollar higher. The 200-day moving average has been broken above, along with the late-July downtrend and the 38.2% Fibonacci retracement of the January to June move.