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U.S. Dollar Exchange Rates: Analyst Reactions to Federal Reserve's Landmark Policy Shift

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- USD hits the ropes after landmark shift in Federal Reserve policy.

- Number and pace of rate hikes to fall given global economic risks.

- Fed has dented stocks, lifted bond prices and wiped floor with USDs.

The U.S. Dollar retreated further from 18-month highs Thursday after the Federal Reserve signalled a landmark shift in its interest rate policy, and could now be on course for even further losses.

That has enabled currencies like the Pound and Euro, which were crushed by a strong Dollar this year, to recover some lost ground and may yet see them rise further during the months ahead. 

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.

Economies all over the world have slowed this year and stock markets have almost all wracked up double-digit losses in the last three months.

Those developments could ultimately lead to a slowdown in the U.S. economy if financial condition continue to tighten and business as well as household confidence becomes meaningfully impaired.

As a result the so-called dot plot of policymaker projections for rates now shows a clear majority of the Fed board anticipating only two hikes next year, with five of the 12-man Federal Open Market Committee revising projections lower.

Previously four members had projected rates would rise all the way to the "neutral" 3.5% level next year, implying four h hikes for 2019, 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 before it becomes appropriate to . 

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.

The Pound-to-Dollar rate was quoted 0.22% higher at 1.2653 during noon trading Thursday, although it's been higher, but is still down -6.25% for 2018.

The Euro-to-Dollar rate was 0.51% higher at 1.1444, after rising 0.71% earlier in session, and is now down by a reduced -4.58% for 2018.

The U.S. Dollar index was -0.51% lower at 96.48 after having pared its 2018 gain all the way back to just 4.58%.

The 10-year U.S. yield was down -0.80% at a seven month low of 2.75%. That begun the week at 2.85% and entered December at 3%.

The S&P 500 was down -0.48% in early U.S. trading after a steep drop in the previous session. All European major stock markets were down more than 1%, with Spain's IBEX leading the pack after declining -2.57%.

Ironically, the bank's expression of concern for markets has simply deepened the rout in global stocks because of what Fed acknowledgement of those global economic risks means for the corporate earnings outlook.

If economic risks are sufficient enough to change Fed policy then they are also enough to pose a threat to earnings and the lofty valuations that stocks have reached during recent times.

Analysts have different views on the likely implications of all this for global currency markets and individual exchange rates next year so a range of them are featured below.  

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Kit Juckes, chief FX strategist at Societe Generale 

"This might have been almost exactly what the market supposedly expected, but it didn't prevent a sharp sell-off in equity markets, a sharp fall in treasury yields, a flattening in the yield curve, and weakness for risk sensitive currencies."

"It all seems a bit overdone, but then it's the time of year for overdoing things so we should take these moves with a pinch of salt."

"EUR/USD remains a bit of a sideshow, but technically, Stephanie and co suggest a break of 1.1445 should signal a test of the 1.15-1.1530 area that could be the door to a more meaningful rally."

"My problem today, as has been the case for a while, is that there isn't any home-grown European cause for currency optimism."

"EUR/USD is 10% below its 10-yer average level, and 14% below PPP but cheapness alone isn't a good reason to pile in with eyes shut."

 

Daniel Katzive, head of FX strategy, BNP Paribas

"We continue to see the Committee lift rates twice more next year, as the data stays strong enough to pressure the unemployment rate downward. Risks remain on the side of an earlier pause."

"We think the currency is likely to remain vulnerable until rates markets move closer to pricing our expectation for two more rate hikes next year."

 

Brent Donnelly, FX trader, HSBC 

"After 16 straight days on a 1.1300 handle, could today be the day EURUSD finally closes somewhere else? I hope so."

"This equity selloff feels more like a market and liquidity event, not an economic event, and so anything that is exposed to short equities (like USDJPY) is a bad trade now, I think. I stick with the EURUSD view given the extreme undervaluation relative to rate differentials, gold and Italian spreads."

"The story continues to be the end of US exceptionalism....As the US story peaked in early October (when Powell goofed and said the US was far from neutral, and I wrote the piece about economic nirvana in Kikwanaland), the dollar stopped going up...As US equities underperform, so should the dollar."

"There are probably better USD pairs than EURUSD to be short dollars but I am still thinking about what to rotate into."

"USDTRY, USDCAD, USDZAR and NZDUSD all look like reasonable options but for now the EURUSD idea remains."

 

Derek Halpenny, European head of research, MUFG

"Surprisingly, the FOMC made no reference to the dramatic drop in market-based measures of inflation expectations. The 10yr breakeven ate has dropped 40bps since early November. Crude oil prices continue to fall with NYMES now down 40%. The Fed will find it increasingly difficult to justify a Q1 rate hike if these disinflationary market influences continue."

"The S&P 500 is now down 15% from the most recent high while crude oil prices are now nearly 40% lower. The MUFG GMR view is for two rate hikes next year, so we are certainly in the camp of a slower pace of rate hikes in 2019. The direction of travel in financial markets must be a concern. The 2019 futures strip has now removed 43bps of hikes since 8th November. Despite this risk assets continue to sell off."

"Regular readers will be aware of our dollar bearish view for 2019 and we certainly believe the Fed communications yesterday are consistent with some depreciation next year. Expectations are high of a global slowdown in 2019 but we see that slowdown as modest and therefore consistent with some increased appetite for nondollar assets in circumstances of a more marked slowdown in the US. G10 currencies like NOK, SEK and GBP are very undervalued and offer scope for outperformance."

 

Ian Shepherdson, chief U.S. economist, Pantheon Macroeconomics

"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."

"Not a single FOMC member now expects rates next year to reach 3.375%; previously there were four at that level and one at 3.625%."

"This looks to us like a worrying case of groupthink; the end of 2019 is a long way away, and a trade deal with China, coupled with a surge in wage growth, is an entirely plausible outcome, which almost certainly would require rates to rise more than 50bp next year."

"The Fed’s forecasts are very skewed, in our view, and the risk of them coming unstuck is not insignificant. Ultimately the data will tell them what to do, and we think the labor market is primed to give the Fed a bloody nose, assuming a trade deal can be done."

 

Steven Blitz, chief U.S. economist, TS Lombard

"Powell’s balancing act yesterday was to stop hiking without conveying that he is propping up the equity market or worried about growth. He did so by declaring that the funds rate is neutral. As such, there is no longer a predetermined upward trajectory for rates, just tweaking around a growth forecast. And the FOMC will always forecast growth. Otherwise, why raise rates this month?"

"Should the economy, as the Fed expects, accelerate next year and push down unemployment with inflation ticking higher, the funds rate will go up 50bp to 2.75%-3.00%, the FOMC’s longterm objective." 

"What Powell says at next month’s FOMC meeting and does in March consequently looms large. We do not believe the US economy is falling into recession. Much of what is going on in the capital and loan markets is a repricing to reflect the return of cash as a viable asset, and this is squeezing credit. We still think Powell understands this."

"By claiming the funds rate is neutral, he has given himself a free option to do nothing and lower forward guidance further. This is all reason enough for us to think he will not raise rates in March."

 

Christ Turner, head of FX strategy, ING Group

"The dominant reaction in financial markets has been one of caution, with price action largely driven by equities. Here investors are still overweight both US equities and the dollar. Concerns over late cycle tightening from the Fed has seen the market turn to the safe haven of the JPY."

"This trend could extend a little further, but these developments have not come as a complete surprise to investors, where cash allocations are already relatively high. $/JPY could extend to recent lows at 111.40 and DXY drop to 96.00/96.35, but we suspect that 2%+ deposit rates can limit the scale of outflows from the dollar."

 

Mark McCormick, head of FX strategy, TD Securities

"It is clear that US risks asset should continue to correct but what it is not clear is whether this stokes a real economy recession next year."

"Price action reflects the unwind of easy money and years of financing engineering, though the Fed's not sure how soon (or much) this spills into the real economy. What's clear to us, however, is that this backdrop reinforces the steady climb down in the broad USD."

"This backdrop sees the correlations flipping again and reveals new dynamics like the strength in JPY and EMFX noticed the past few sessions. The EUR has reached our short-term target of 1.145, which shifts the focus to a possible break of 1.15. A weaker USD lifts all FX boats and yet CAD should lag the rally, as NA risk assets underperform the ROW."

 

Esther Reichelt, analyst Commerzbank

"The only marginally lower rate path should support the dollar, as this means that the recent fall in Fed rate hike expectations was exaggerated. The only problem is: the market clearly does not believe the Fed’s scenario."

"The flat rate curve suggests that contrary to the Fed, market participants harbour considerable concerns about a recession. So in the end the dollar outlook depends on who will turn out to be correct: the market or the Fed."

"In our view the Fed’s outlook is more realistic as the US economy is not (yet) showing any signs of a significant downturn."

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