U.S. Fed Cuts Interest Rates, Pound-to-Dollar Extends Recovery but Expect Sterling Gains to be Limited

- Fed delivers emergency interest rate cut
- USD weakens
- But markets were expecting this, limiting USD decline
- Further rate cuts expected by economists

Above: File image of Federal Reserve Chairman Jerome Powell. Image © The White House

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The U.S. Dollar lost purchasing power after the U.S. Federal Reserve delivered an emergency 50 basis point interest rate cut on Tuesday, a move aimed at preempting any financial slowdown stemming from the coronavirus outbreak.

The target range for the federal funds rate, is now down to 1.0% to 1.25% and economists are expecting the Fed to deliver further interest rate cuts at some point in coming months, a scenario that would likely limit U.S. Dollar upside.

"My colleagues and I took this action to help the U.S. economy keep strong in the face of new risks to the economic outlook," said Federal Reserve Chairman Jerome Powell in a communiqué following the decision. "The spread of the coronavirus has brought new challenges and risks. The virus has afflicted many communities around the world, and our thoughts and prayers go out to those who have been harmed. The outbreak has also disrupted economic activity in many countries and has prompted significant movements in financial markets. The virus and the measures that are being taken to contain it will surely weigh on economic activity, both here and abroad, for some time."

The decision to cut interest rates comes following a series of Tweets from President Donald Trump complaining that U.S. interest rates were too high. In response to the Fed's move Trump suggested more should be done: "the Federal Reserve is cutting but must further ease and, most importantly, come into line with other countries/competitors. We are not playing on a level field. Not fair to USA. It is finally time for the Federal Reserve to LEAD. More easing and cutting!"

There was a textbook reaction by the Dollar to the announcement as it weakened across the board: the Pound-to-Dollar exchange rate is now 0.30% higher at 1.2802 while the Euro-to-Dollar exchange rate is at 1.1148.

The Dollar index - a measure of broad-based Dollar performance against the world's most liquid currencies - was 0.21% lower at 97.31.

To be sure, the decline in the Dollar is by no means substantial, potentially because markets saw this interest rate coming. Indeed, U.S. stock markets have not advanced on the back of the cut, with the majority of this week's gains coming at Monday's close when market's got wind of an emergency cut.

If we look at the Dollar index we can see it has been declining since February 21 as markets quickly built into their thought process that the global slump in stock markets stemming from coronavirus concerns would prompt a reaction by the Fed.

With a cut now delivered, the question becomes how many further cuts are in the pipeline: if there are more we would expect further downside in the Dollar, but signs that this is a one-off cut and the Dollar might find its feet once more.

"The Fed largely delivered on expectations with an emergency 50bp rate cut this Tuesday. The Dollar was initially weaker across the board, with high yield FX performing strongly. However, a very uncertain equity environment means that volatility will stay high and it looks too early to be jumping back into carry trade strategies," says Chris Turner, Global Head of Markets and Regional Head of Research for UK & CEE for ING Bank.

Turner says the foreign exchange market will remain wary that the Fed's measures will only provide temporary relief to global equity markets. Indeed, Powell himself said the ultimate tonic for the global economy would be a medical solution and ultimate containment of the outbreak.

"Our team is very cautious on risk assets and believe the Fed will be called again into action over coming quarters. We see EUR/$ moving to 1.15 and $/JPY to 105 over coming months, with volatility staying high," says Turner.

Powell says the Federal Open Markets Committee (FOMC) - who are tasked with setting monetary policy - are beginning to see the effects on the tourism and travel industries, and are hearing concerns from industries that rely on global supply chains.

Powell does however note the magnitude and persistence of the overall effects on the economy remain highly uncertain, and the situation remains a fluid one.

Against this background, the FOMC judged that the risks to the U.S. outlook have changed materially and were spurred into action.

"In the weeks and months ahead, we will continue to closely monitor developments and their implications for the economic outlook, and we will use our tools and act as appropriate to support the economy," adds Powell.

#FOMC Chair Powell answers a reporter's question at the press conference: https://t.co/wKKDeEOmWg pic.twitter.com/sL9RCPeK7K

— Federal Reserve (@federalreserve) March 3, 2020

Following this surprise move to cut interest rates, markets will be pondering the prospect of further cuts.

"As we think the situation will deteriorate before it turns better, it is difficult for us to see why the Fed should not cut further. By cutting the Fed funds target range, the Federal Reserve has ensured that monetary policy is now neutral instead of tight," says Mikael Olai Milhøj, Senior Analyst at Danske Bank.

With regards to currency markets, Milhøj says the current spot level in EUR/USD is now elevated following the stellar run over the past ten days, he expects it to trade towards 1.11 short-term if risk sentiment improves only mildly.

"Should this policy action not be enough, declining equity prices continue to be a EUR/USD positive factor," says Milhøj.

"Are other Fed cuts now possible? Yes. Especially if signs of contagion are seen in U.S. economic numbers, particularly those related to confidence, which were still very high. Movement by the indicators will therefore be under a close watch," says François Dupuis, Vice-President and Chief Economist at Desjardins, the Canadian bank.

Desjardins now expect the Bank of Canada to follow suit and announce an interest rate cut on Wednesday, as part of a coordinated global response to the coronavirus outbreak.

On Tuesday the Reserve Bank of Australia cut interest rates to the lowest level on record, while expectations are elevated that the Bank of England will deliver a cut before month-end.

This should keep a lid on any Sterling strength over coming days and keep Pound-Dollar exchange rate rebounds limited.