Dollar Holds Steady As Powell Laces Forecast Cuts With Optimism

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Daily FX Market Roundup 12.18.2018

By Kathy Lien, Managing Director of FX Strategy for BK Asset Management.

On paper, it should be no surprise that the dollar rallied after a Federal Reserve rate hike but Wednesday’s gains were unexpected for a few reasons. First, most investors were looking for Fed Chair Powell to be dovish and when he lined his comments with optimism, the dollar rose. Secondly, the dollar rallied despite the fact that 10-year Treasury yields dropped to an 8-month low. Rate-hike expectations also declined with the market now pricing in a greater chance of a rate cut than a rate hike in 2020. All of this combined with downgraded GDP and inflation forecasts should have driven the greenback lower but instead, the dollar rallied because the tweaks to the policy statement weren’t dovish enough.

Investors had braced for the worst – from no rate hike to dissents and a change in the risk assessment. And while there were subtle tweaks in the statement and lowered growth and inflation forecasts, these changes were not as significant as the market had hoped. The same was true of Fed Chair Powell’s comments – he made it clear that nothing is predetermined and everything is data dependent but he also said the sharp decline in US equities and the tightening of financial market conditions has not fundamentally altered the bank’s outlook. The Fed still plans to raise interest rates next year and most policymakers expect the economy to grow. Compared to the rest of the world, it could be one of the very few central banks tightening in the first half of 2019 and this possibility lent support to the dollar, preventing the currency from falling further. However the bond market is usually right and it will be difficult for the dollar to sustain its gains if yields continue to fall.

At the end of the day, even though the Fed is holding onto its positive outlook and putting on a brave face, the main takeaway is that the Fed will only raise interest rates again if data improves. So the path of least resistance for the dollar is lower with EUR/USD likely to find its way back above 1.1450 and USD/JPY headed for a move below 112.

Dollar Holds Steady As Powell Laces Forecast Cuts With Optimism

Takeaways From December’s Rate Call

Next up is the Bank of England. Sterling is trading off its lows ahead of the UK central bank’s final policy meeting of the year. Unlike the Fed, there will be no changes to interest rates. The last time the BoE met, it sent GBP/USD soaring above 1.30 on talk of rate hikes. According to the summary of the report that month, the MPC said “Were the economy to continue to develop broadly in line with the November Inflation Report projections, an ongoing tightening of monetary policy over the forecast period would be appropriate.” To add to that, Governor Carney said a Brexit deal could release pent-up investment demand but a no-deal Brexit could also lead to a major supply shock that could drive up inflation and interest rates. Fast forward 7 weeks and the UK is no closer to a Brexit deal. Data isn’t terrible but it hasn’t been great either – while labor-market activity is up and wages increased, retail sales continued to fall as manufacturing- and service-sector activity slowed. The FTSE is also down 4.5% since the November meeting. None of this hardens the case for BoE tightening but the big question is whether it weakens it enough for the central bank to address it. Internally, the answer is ‘yes’ but publicly, we think the answer will be ‘no’ for the BoE. They’ll probably mention the risk of ongoing Brexit uncertainty but they may delay guidance changes to next year on the hope that there will be more Brexit certainty in the next few weeks.

Dollar Holds Steady As Powell Laces Forecast Cuts With Optimism

GBP Data Points

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