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Dollar Bulls Betray Uncertainty in Wake of Federal Reserve Rate Hike

© Dmytro Synelnychenko, Adobe Stock

- USD mixed in response to latest guidance from Fed

- Global stock markets fall sharply amidst fears of further tightening

- Dollar living on borrowed time say TD Securities

The U.S. Dollar was initially bid higher after the Federal Reserve raised its interest rate for a fourth time in 2018, but said it will slow the pace at which it raises borrowing costs next year. Indeed, in European trade the Dollar is seen to be under pressure, suggesting markets are increasingly of the belief that Fed policy won't be supportive in 2019.

The overall tone from the Fed was important with investors opting to press the sell button ensuring the December slump in global stocks extends. Indeed, according to Reuters data, U.S. stocks are on pace for their biggest December decline since 1931, the depths of the Great Depression.

"Markets expected the Fed to at least sugarcoat its 25bps rate hike but got disappointed. The Fed’s rather upbeat assessment and determination to continue policy normalisation at only a slightly slower pace sent equity markets and U.S. yields tumbling. We expect risk-off sentiment to spur further market repositioning today," says Piet Lammens, a currency strategist with KBC Markets in Brussels.

The Yen is outperforming as traders liquidate equity holdings and seek out 'safe haven' assets. The Dollar would typically also catch a bid under such scenarios, but the Greenback's response is less clear: the Pound-to-Dollar exchange rate is higher on the day at 1.2685 while the Euro-to-Dollar rate is sizeable 0.4% up at 1.1429.

Currency markets are still digesting details of the statement and the Fed's latest economic forecasts but for now, some analysts say divergence between U.S. and rest-of-world monetary policy remains clear and that this should support the Dollar. 

"The difference between the current strength of the U.S. economy and the immediate outlook for the Fed funds rate, remains in direct contrast to the current slowing of the European and Asia economies, as well as the immediate outlook for monetary policy," says Adam Myers, a currency strategist at Commonwealth Bank of Australia

But for others, the Dollar's time in the sun will soon come to an end.

"The combination of a lower dot plot across the horizon and increased monitoring of global developments suggest the USD is living on borrowed time and a realignment towards a lower rates trajectory is in store," says Michael Hanson, Head of Global Macro Strategy at TD Securities in response to the rate hike.

The mixed market reaction to the Fed's December policy event is matched by a mixed assessment on the Dollar's outlook by the analyst community. "Such price action raises an important question as to whether the market’s psychological response to ‘less hawkish’ / ‘more dovish’ policy moves is changing," says Gajan Mahadevan, a quantitative strategist with Lloyds Bank.

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Less Rate Rises in 2019

Policymakers lifted the Federal Funds range to between 2.25% and 2.5% Wednesday, in line with market expectations, but they flagged global economic and financial market developments as a growing threat to the U.S. economy.

Those risks could ultimately prevent the Fed from raising rates much more next year, although changes to the guidance are frequent and often prone to being reversed or adapted further down the track.

The so-called dot plot of policymaker projections for rates now shows a clear majority of Fed rate setters anticipating only two hikes next year. Five of the 12-man Federal Open Market Committee have revised projections lower.

Previously four members had projected three increases next year and one had pencilled in four. But the FOMC now appears to be converging with the market's view that only one or two rate hikes are likely to be needed for 2019. 

Above: Federal Open Market Committee 'dot-plot'.

In addition, the Fed slashed its estimate of the so-called long-run neutral rate from 3% to 2.75%. In English, this means policymakers are fearful the economy is less able to cope with higher rates than previously thought.

"Having said that, we do not expect the USD to put on significant gains because the FOMC have indicated that they are close to the terminal Fed funds rate," adds CBA's Myers. 

Changes in rates are normally only made in response to movements in inflation but impact currencies because of the influence they have over capital flows and speculative money.

U.S. inflation has remained consistently above the 2% target this year but risks to the economy flagged by the Fed could easily undermine the inflation outlook if and when they materialise.

The Dollar had declined steadily over the first half of the week after having touched an 18-month high on Monday, as markets bet the Fed would signal a 'dovish' turn in its policy stance. 

"Market volatility, growth concerns, and limited inflationary pressure have investors wondering whether today’s rate hike might be the last this cycle. The updated policy statement and projections certainly leaned dovish but hardly validated market pessimism," says Josh Nye at RBC Capital Markets.

Above: Pound-to-Dollar rate shown at hourly intervals.

The U.S. Dollar index was 0.1% higher at 97.08 following the announcement after reversing an earlier -0.21% decline.

The GBP/USD rate was -0.33% lower at 1.2612 and is down -6.55% for 2018, while EUR/USD was down -0.04% at 1.1401 and -4.98% for this year. 

The Dollar index has risen by 5.2% in 2018 after reversing what was once a 4% year-to-date loss wracked up mostly during the first quarter.

A superior performance from the U.S. economy was behind the move, because it enabled the Federal Reserve to go on raising its interest rate as economies elsewhere slowed and the respective central banks sat on their hands.

Above: Euro-to-Dollar rate shown at hourly intervals.

Consensus for a shift in policy had developed as investors grew ever more concerned about the impact President Donald Trump's 'trade war' against China is having on the U.S., Chinese and global economies.

Market volatility, which has seen global stocks wrack up double-digit losses over the last three months, has also contributed to the consensus because of the impact it could have on household and business confidence. 

Investors have also been anticipating that U.S. economic headwinds will mount next year as the stimulatory impact of President Donald Trump's tax cuts fades.

After all, with growth having reached a four year high in 2018, producing a better performance next year will be a tall order for the economy to fulfil. But not everybody buys the Fed's message that it will take 2019 a bit more slowly.

"It appears, then, that the FOMC is putting more weight on the market turmoil than the recent run of softer data from the industrial economy, which begs the question of what they’ll do if the administration strikes a substantive trade deal with China - as we expect by the spring - and the market rebounds strongly," says Ian Shepherdson, chief U.S. economist at Pantheon Macroeconomics. "This looks to us like a worrying case of groupthink."

Shepherdson says the U.S. economy remains in good relatively good shape, the labour market is healthy and wages for workers are rising.

He projects another increase in U.S. inflation next year as a result, which could force the Federal Reserve to backtrack on Wednesday's guidance and raise rates more than twice that year.

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