Pound Jumps against Dollar as Markets Smell Federal Reserve Rate Cuts in H2

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The Pound, Euro and other major currencies rose against the Dollar in an initial response to the Federal Reserve's decision to raise interest rates by 25 basis points.

The accompanying statement suggested little alarm over the recent stresses in the U.S. financial system. The FOMC voted unanimously to increase its target for the federal funds rate to a range of 4.75% to 5%, the highest since September 2007.

In what is interpreted as a 'dovish' development, the Fed's Statement dropped wording pertaining to the need for "ongoing increases" in interest rates.

Instead, the Fed says "some" further tightening "may" be appropriate.

The Pound to Dollar exchange rate rallied to a high of 1.2304 on the 'dovish' elements, before settling back to 1.2290.

The Fed's new set of forecasts, detailing where members of the FOMC see interest rates going over the coming months, revealed one further hike was likely before the cycle ends.

"The Fed is juggling beating inflation, avoiding recession and making sure the financial system remains secure. That is quite a challenge and, unsurprisingly, they have moderated their stance on inflation and gone for a 25bps hike. This was accompanied by comments which indicated that further tightening may be necessary, although that language is softer than last time," says Neil Birrell, Chief Investment Officer at Premier Miton Investors.

In particular, Birrell cites the Fed noting that although the banking system is sound, there is a risk to growth from tighter credit conditions.

"This looks like a pragmatic approach by the Fed, one that will calm nerves and show that they are attentive to all the risks around at present," says Birrell.

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In the press conference, Powell was asked if the FOMC considered pausing rate hikes following turmoil from banks globally.

He said they considered it.

The Market Smells Cuts

The Dollar's selloff reflects market expectations for the Fed to cut interest rates in the second half of the year as a response to a slowing economy.

In fact, money markets show expectations for four rate cuts, starting in June.

But as mentioned earlier in the article, the FOMC projections do not envisage such rate cuts in 2023.

The Fed and the market are therefore highly divergent on what the outlook holds for rates.

This could spell volatility in financial markets over the coming weeks as the Fed and the market butt heads.

The Dollar would likely snap back and go higher if investors are forced to price out the cuts they are now predicting, an outcome that becomes more likely if U.S. inflation remains elevated and economic growth proves resilient.

But Powell acknowledged the recent stress in the banking system was tightening financial conditions, i.e. making the cost of borrowing higher and making loans harder to come by.

This is an obvious reaction by banks that are becoming more cautious.

This tightening in financial conditions will slow the economy and the Fed could relent if the economy goes into reverse and a recession ensues.