The signals of last night’s monetary policy decision by the US Federal reserve appear to have been misread. In fact, the initial reaction across equity, treasury and FX markets appeared to imply that markets expected the FED to raise rates during this meeting, despite their persistent and vocal admonitions that a rate hike is not expected until the US central bank’s next monetary policy meeting.
This meeting of the Federal Reserve Bank of America was not followed by a press conference from the Committee’s top officials and Chairman, Jay Powell. Therefore, little else can be mined from the decision apart from the headline “no hike” decision, and the publication that accompanied and contextualised it.
The monetary policy decision provided one of the most hawkish signals plausibly possible, short of an actual interest rate hike. Short-term interest rates were held by the US central bank within a band of 1.5-1.75 per cent – the level reached following a rate hike at their last monetary policy decision in March. Following this decision, and a turn to a tone biased towards tighter monetary policy, the US Dollar has appreciated dramatically.
Despite not being expected to unveil a rise in underlying interest rates, the run up to the event was characterised by great anticipation, discourse and attention. The reason for the heightened attention to the decision was the significant tick up in inflation during the last reading of the general price level in March. Moreover, the yield on US 10-year treasury broke through the highly significant and psychological 3% threshold eight days ago.
During previous monetary policy decisions, the post-meeting statements and public speeches by US policy makers, the FED has been swift to announce that the Committee was “closely monitoring inflation”, largely in an attempt to ensure that this round of monetary policy tightening was not detrimentally affecting the very variable that the mechanism is designed to control; inflation!
Following the convergence of the observed annual change in the actual price level and the FED’s economic target and mandate, the central bank was willing and able to adapt this phraseology and, instead, include a sanguine message about inflation expectations. This precipitated the expectation that the FED on the whole does, as expected, feel liberated to raise interest rates as it sees fit and prudent over the medium-long run. Despite all these hawkish signals and visions of a strong underlying economy, the differential between the 2 year and three-year bond does at present suggest that the FED’s current round of monetary policy tightening will fade into an easing of monetary conditions (and looser policy) by 2020.
As discussed above, the relationship between interest rates (both those determined by policy and implied by treasury) does have a significant and causal impact upon the value of the domestic currency. As such, this decision might have been expected to see the Dollar rally significantly.
At 7p.m. London time yesterday, however, the US trading session saw the Dollar shed value, in a counter intuitive decision that suggested, somehow, markets had expected even more – perhaps even a hike! The Dollar dropped down by as much as 0.35% within a minute of the decision. However, within the hour markets appeared to re-evaluate and internalise the decision to restore the greenback with an additional 0.5% of value to allow the dollar to rally towards an intraday high on a trade-weighted basis. Following this decision, with traders mimicking the classic chuckle brokers catch phrase, the Dollar encroached upon the Euro and the Pound to trade at a value of 1.1939 and 1.3562 respectively. Moreover, bond yields that had fallen in the first minutes following the decision rallied back towards 3% on the 10-year note.
As trade tensions appear to ease following optimistic and somewhat restrained comments by President Trump and Secretary of the Treasury, Steve Mnuchin, the Dollar has received a sizeable bid. Whilst the scope does look clear for further dollar strength as the coupling of interest rates and exchange rates continues to re-establish itself as a credible macroeconomic relationship, the Dollar’s run could still prove to be short lived. The Dollar will face serious technical resistances both against the Pound and the Euro, likely to at least partially stunt its appreciation against its two international dominant reserve counterparts.
Discussion and Analysis by Charles Porter