Why the US Dollar Fell

The US Dollar exchange rate complex came under pressure following the US Federal Reserve’s decision to raise interest rates 0.25% ensuring their upper band on interest rates sits at 1.0%.

However, this was expected and cannot be said to be the reason for the decline.

Foreign exchange markets are forward-looking in nature, therefore what mattered was guidance on future rates.

The communication from Janet Yellen and her team of Governors is that markets should only expect two more interest rate rises in 2017; markets might have been hoping for three.

Kit Juckes, an economist at Societe Generale says:

“The FOMC ‘dotplot’ saw a bit of movement but none that mattered. The median projection for rates at the end of this year is 1.375%, end 2018 is 2.125, end 2019 is 3 and the ‘longerterm;’ median is 3% too. The market was expecting some upward revisions and got none, seeing instead a slightly faster pace of rate increases for now but no change to the eventual destination.”

The dot plots represent the levels each voting member believes future interest rates should be set at.

Therefore it is a solid signal as to future US interest rates.

“The Fed’s reluctance to send a clear signal that there is more tightening to come, as opposed to a timid signal that they may goal bit quicker, has disappointed markets,” says Juckes.

Below: December's dot plot graph:

Below: The dot plot released in March’s projections:

Michael Gapen at Barclays believes the economy’s recent performance of late justifies the Fed’s decision to play a cautious tune:

“The Fed had not seen enough improvement in the outlook to signal that it was ready to normalise policy faster.”

When asked whether the Fed would upgrade its outlook for the US economy on expectations of fiscal policy as the IMF and OECD had done recently, Chair Yellen replied, “we have plenty of time to see what happens.”

“We feel this statement accurately encapsulates what happened at the March FOMC meeting; the Fed felt it had seen enough to follow through on its policy plans in a way it had not in the past, but clearly felt it had not seen enough to signal anything more radical than that,” says Gapen.

While the Dollar has suffered in the wake of the decision, John Silva, Chief Economist at Wells Fargo says the Dollar should ultimately continue to strengthen.

“Other central banks around the world are challenged. Since the ECB and BOJ are not in a position to raise rates, actions by the Federal Reserve will not be followed and thereby the Dollar’s exchange value rises. This will promote financial capital outflows,” says Silva.

Indeed, Silva suggests it is too soon to believe only two interest rate rises will be delivered in 2017.

“A March rate hike puts in place an easier path for the FOMC to raise rates three times in 2017, particularly given that Chair Yellen’s term ends in February 2018,” says Silva.

Beware an Overheating Economy

The Fed would do well to pursue an agressive path of rate hikes if it is to ensure the US economy does not overheat.

Heading into the meeting, New York Fed President Dudley justified action at the March meeting by saying that “animal spirits had been unleashed,” sentiment had improved “quite markedly”, and the stock market is “up a lot”.

"While not as strong as comments made by Boston Fed President Rosengren in recent months, Dudley’s comments suggest that some on the committee may have been willing to move in March to prevent excessive risk taking and preserve medium-term financial stability," says Gapen.

Nevertheless, those hoping a Fed fulfilling its expectations for gradual rates hikes would dampen market enthusiasm may have been disappointed as equity markets rallied sharply, the Dollar fell against major trading partners, and longer-dated Treasury yields fell.