How Does the Fed?s Policy Decision Affect Global Currency Forecasts?

December 14, 2016 - Written by Frank Davies

STORY LINK How Does the Fed?s Policy Decision Affect Global Currency Forecasts?

The Federal Reserve’s Wednesday policy decision continued to have a strong effect on global foreign exchange markets on Thursday afternoon.

Demand for risk-correlated currencies like the Australian Dollar and New Zealand Dollar remained limited, while the US Dollar continued to surge against rivals with a close negative correlation like the Euro and Japanese Yen.

This US Dollar strength will depend on whether this hawkish outlook remains however, as there is much uncertainty in the US economy going ahead into 2017 due to the incoming Trump administration.

[Previously updated 15/12/2016]

The Federal Reserve has managed to both meet and defy market expectations as a result of their latest monetary policy announcement.

On the one hand, Janet Yellen announced that interest rates would be increased by 0.25% as expected, while on the other the Fed chair surprised by stating that policymakers expected three rate hikes in 2017 rather than two as previously suggested.

[Previously updated 14/12/2016]

The Federal Reserve’s latest monetary policy decision is just a few hours away from being announced. Markets have been eagerly awaiting it, so does that mean it has already had all the impact it is going to have on the major currencies?
Here’s a rundown of how the outcome of today’s policy meeting may alter the trajectory of several major currencies.

’Dovish Hike’ Could Threaten to Undo Recent USD Exchange Rate Gains

With the US hike virtually priced into the US Dollar, the bigger question traders want answered is; ‘How does this change the outlook of monetary policy in 2017?’ Investors aren’t after a one-off hike.

As Credit Agricole notes;

‘The Fed’s dot-plot might ultimately prove the biggest market mover on the day. Recent data has been more upbeat and the unemployment rate fell below the Fed’s NAIRU [non-accelerating inflation rate of unemployment] in November. This should be reflected in more optimistic Fed projections for growth, inflation and employment.’

If the Fed offers a ‘dovish hike’, stating that the outlook for policy in 2017 remains the same or worse as previous projections, USD exchange rates could tumble. A ‘hawkish hike’, on the other hand, would likely lift the US Dollar further as markets begin to price in more hikes to come.

GBP Could See Safe-Haven Demand Similar to Post-US Election on Fed Dovishness

In the volatile period surrounding the US election, the Pound emerged as something of a safe-haven for investors caught between the unsettled US Dollar and Euro. Since the elections on November 8th, GBP/USD has climbed 2.6%, while GBP/EUR has gained 7%.

Considering there is a lot of volatility in the Eurozone from the Italian banking and Greek bailout crises, as well as the potential for further instability next year, the Pound could find itself in high demand again, should the outlook for US monetary policy remain soft. This all depends on how the Bank of England (BoE) responds to the latest strong inflation data in tomorrow’s Monetary Policy Committee (MPC) meeting.

Prospect of Widening Fed Policy Divergence Could Undermine EUR Further

The Euro and US Dollar are the world’s most traded currencies, meaning that strength in USD inevitably weighs on EUR. Rising borrowing costs in the US would also create an even bigger rift between the States and the Eurozone, where benchmark rates are stuck at 0.00% and quantitative easing is in full effect.

Signs of further hiking to come will therefore weigh on the Euro, suggesting even wider policy divergence. This lowers the appeal of the Euro; as well as weakening trade revenues, it also encourages investors to borrow Euros and low interest rates and convert them into Dollars to buy higher-yielding US assets.

But if the policy outlook doesn’t change, Euro exchange rates could advance bullishly. EUR may be in luck, as according to Mark McCormick of TD Bank Securities;

‘We look for a dovish-hike with Yellen likely to emphasize … that the policy trajectory is not on a pre-set course and ultimately the Fed’s stance will hinge on the data. We also look for an unchanged dot-plot, suggesting that the Fed is unlikely to front-load fiscal policy expectations into its outlook.’

Will AUD Suffer as Stronger US Dollar Weakens Commodity Prices?

Global commodities are priced in US Dollars, which could see an interest rate hike threatening the Australian economy. Should the US Dollar rise higher, its increased purchasing power will see commodity prices fall.

Because this will have a knock-on global effect, the Australian economy could be weakened; Australia exports a lot of iron ore to China, which will find it more affordable to buy thanks to the US Dollar weakening prices. With its main export becoming less lucrative, Australia may find its GDP squeezed, even if it is trying to transition away from mining.

This means AUD could be on a bearish footing going forward, if the Fed’s ‘hawkish hike’ materialises.

NZD Could Fall; Will New Zealand Debt Still be as Attractive?

New Zealand has a rather interesting combination; risky currency and incredibly safe government debt. Compare this to somewhere like South Africa, where the currency is highly volatile and government debt is barely clinging on just one notch above ‘junk’ status.

New Zealand’s strong economic fundamentals make its government debt highly attractive, as does the country’s relatively strong interest rates. Among developed nations, New Zealand’s 2.00% interest rates are considered fairly lucrative, but this appeal could be under threat if the Federal Reserve keeps normalising policy.

This would see the New Zealand Dollar weaken - investors have to pay for New Zealand government bonds in NZD, meaning they first need to convert their foreign currency, fuelling demand for the ‘Kiwi’.

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