Hike rates

Why are traders selling dollars after the Fed pledged to aggressively hike rates?

Editor’s note: Jimmy Zhu is chief strategist at Fullerton Research. The article reflects the opinion of the author, and not necessarily the views of CGTN.

A hawkish central bank is generally seen as a positive for its currency, but the dollar surprisingly failed to rise after March’s meeting of the Federal Open Market Committee (FOMC) turned out to be more hawkish than expected. many market players had predicted this. Going forward, a more aggressive Fed could even pressure the dollar to fall further.

The Fed officially kicked off the tightening cycle at the FOMC meeting in March by raising the benchmark policy rate by 25 basis points, as widely expected earlier. But its members’ forecasts for a further six-fold increase in the rest of the year surprised many market participants. If such a pace of rate hikes were to materialize, the current tightening cycle would be the most aggressive since 2004-2006, when the Fed raised rates 17 times during that period.

At the press conference, it should be noted that Fed Chairman Jerome Powell warned of high inflation through the middle of the year and that the tight labor market has reached “an unhealthy level “. He said wage increases will have to slow in order to calm inflation.

What he said at the press conference actually opened the door for the Fed to raise rates by 50 basis points in May, as well as to start reducing its balance sheet by $9 trillion this meeting. This kind of expectation should have favored the dollar, as higher Fed policy rates generally increase the value of the currency, but that didn’t happen. The greenback surprisingly fell overnight after the press conference, with the dollar index falling more than one percent since the FOMC statement was released.

Such a bizarre dollar price reaction reminds traders that one cannot blindly expect the dollar to appreciate because of Fed tightening. The currency may face increasing downside pressure due to growing US recession fears and policy divergence between the US and the Eurozone.

The US economic outlook is deteriorating amid aggressive Fed tightening, putting the dollar in a difficult position. Even before the Russian-Ukrainian conflict, the US stock market was already selling off heavily when the persistent rise in inflation weighed. Now, geopolitical tensions have only made the situation worse.

Powell made it clear at the press conference that the Fed would do what it had to do to bring inflation down, while showing little concern for the ongoing conflicts between Russia and Ukraine.

However, the current inflation in the United States is mainly due to shortage of supply and rising commodity prices, and these problems cannot be solved by monetary policies. In other words, if the Fed is determined to dampen inflation, it may consider aggressively tightening policies to significantly weaken demand, a move aimed at balancing supply and demand and slowing the rate of inflation. inflation growth.

But it would increase the possibility of a recession, which is also reflected in the bond market. Previous cycles of Fed tightening have always been followed by recessions, including the period of 1998-2000, 2004-2006, 2016-2018. The 2- and 10-year US government bond yield spread is now narrowing to just 25 basis points, with a flattening curve signaling that traders can widely expect the economic outlook to turn more pessimistic, which will have a negative effect on the dollar.

In addition, the policy divergence between the Fed and the European Central Bank (ECB) could reduce the yield on US and German 10-year bonds, putting downward pressure on the dollar. On Thursday, the ECB’s Christine Lagarde said the central bank was aware of the risk ahead (due to the Russian-Ukrainian conflict) and was ready to revise a plan if necessary, a week after it s pledged to do “everything it can” to curb inflation at the ECB’s latest monetary policy meeting.

A less hawkish policy stance from the head of the ECB led to a rise in the single bloc’s bond yield as the market interpreted that the ECB might allow a higher inflation figure without rapid and aggressive tightening. Any shortage of energy supply (due to the Russian-Ukrainian conflicts) would also have a greater impact on price pressure in the Eurozone than in the United States, the former being more dependent on energy supplies from Russia. .

Thus, euro area inflation could pick up at a faster pace than in the United States later this year, further narrowing the government bond yield differential with the United States, which would be positive for the euro. As the euro weighs more than 50% in the dollar index, any substantial gain in a single currency could easily lower the value of the dollar.

(Cover photo via CFP)