Why currency wars could stave off a Fed rate hike

The dollar has gained against rival currencies in recent months on expectations that the Federal Reserve is on track to raise rates, but following the Fed's warning of a strong dollar, investors are reassessing the timing and size of a rate hike, according to currency strategists.

Minutes from the Federal Reserve's September meeting released on Wednesday revealed the Fed's concern that a rising dollar could slow a much-needed rebound in inflation, currently running below its 2 percent target at 1.7 percent.

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Federal Reserve Chair Janet Yellen speaks during a news conference.
Jonathan Ernst | Reuters

The dollar fell to a two-week low against a basket of currencies in response.

"What is clear is that some members of the FOMC are starting to take note and what is absolutely clear is that a fascinating new phase of the currency wars has emerged," market strategist at BNY Mellon, Simon Derrick told CNBC.

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The question now lies with the Fed and whether they have the "fire power to tackle this assault," Derrick said.

Analyst forecasts have pointed to a strong dollar all year, with some of the more extreme predictions suggesting the currency could appreciate as much as 20 percent against a basket of currencies over the next year.

Expectations on when the Fed will start raising rates vary, with Fed Chair Janet Yellen previously hinting at a rise around spring 2015. But after the Fed's note of caution, investors may now have to factor in further intervention or an even later date before interest rates move, according to strategists.

European Central Bank president Mario Draghi has tried his utmost to "talk the euro" down, and there is little the U.S. can do to stop that, said Derrick.

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"Is there anything the U.S. can realistically do to fight against what Europe is doing with its currency? The answer is no. Europe is doing with its currency what the U.S. did for a decade," he said predicting the euro could plummet to $1.20 against the dollar, down from current levels of around $1.268 in the next three months.

But for some, the discussion at the Fed over growth and the role of the rising dollar has reined in expectations of an imminent tightening of policy.

The euro tumbled to a 22-month low against the dollar at the end of September on the prospect of diverging monetary policy between the Fed and the ECB as data pointed to a U.S. recovery and weak business sentiment in Germany.

"The upside from the euro's loss of purchasing power is that such a move provides stimulus to the regional economy by cheapening its exports. It had tumbled in the face of the stronger dollar all the way to $1.25," chief market analyst at Interactive Brokers, Andrew Wilkinson said.

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"But as investors reshape their perspective on not just the timing, but also the magnitude of policy tightening at the Fed, it seems that for now a genuine catalyst has been put in place to arrest the decline of the euro currency," he added.

Against the yen, the greenback posted the worst two-day loss in eight months on Tuesday after five straight weeks of rises following comments from the New York Federal Reserve President and the Bank of Japan Governor Haruhiko Kuroda.

Bearish strategist Albert Edwards said the yen's descent is more than just a strong dollar on the back of Fed tightening, it is a "weak yen story". But a severe lack of volatility in currency markets over the summer will ultimately drive the dollar higher.

"The next phase of global currency wars may have begun. FX traders have spent the last year desperately running for oases of FX volatility only to find them dry and trendless mirages," said Edwards.

"I think that, in the current circumstances, the yen/$ will head to 120 pretty quickly perhaps after a short reinvigorating retracement. And, if the dollar's ascent is given extra impetus by the DXY (the dollar against a basket of currencies) also breaking out, a decline in the yen below 120 yen will see an end to its 30-year uptrend," he said.