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Pound, Euro Crumble and Dollar Advances after Federal Reserve Signals Higher US Interest Rates

© Dmytro Synelnychenko, Adobe Stock

"The upbeat tone of Fed Chair Jerome Powell’s first semi-annual congressional testimony today suggests that a March rate hike is, as futures markets believe, a near-certainty” - Capital Economics.

The Pound-to-Dollar and Euro-to-Dollar rates slid during noon trading in London Tuesday, as the greenback advanced broadly, in response to Federal Reserve chairman Jerome Powell’s inaugural testimony to Congress.

Powell’s testimony to the the House Financial Services Committee was seen signalling that the recent change of Fed leadership is unlikely to deter the central bank from continuing to raise interest rates, while reinforcing expectations of another hike in March.

The newly appointed chair emphasised that US unemployment rate has remained low at 4.1% while the labour participation rate sat largely unchanged in the second half of 2017, suggesting an economy that is close to full employment.

He also expressed confidence that inflation will eventually return to the 2% target, even with higher rates, and noted a small pickup in wage growth toward the end of last year.

Full employment matters to the Fed, and for interest rates, because when new workers become difficult to find it is often the case that wages begin to rise as companies compete for staff. Wage rises push inflation higher, in most instances, which is enough to ensure the Fed monitors them closely.

“The labor force participation rate remained roughly unchanged, on net, as it has for the past several years--that is a sign of job market strength, given that retiring baby boomers are putting downward pressure on the participation rate,” Powell told lawmakers.

The participation rate rises when those who are unemployed but not looking for a job decide to reenter the labour market and begin looking for work. This is normally a symptom of a burgeoning jobs market but it can also push the unemployment rate higher.

“Although he avoided dropping any heavy hints, the upbeat tone of Fed Chair Jerome Powell’s first semi-annual congressional testimony today suggests that a March rate hike is, as futures markets believe, a near-certainty,” says Paul Ashworth, chief North American economist at Capital Economics.

“Echoing the language used in the most recent FOMC statement last month, Powell indicated that “further gradual increases in the federal funds rate will best promote attainment of both of our objectives”. The minutes of that January FOMC meeting suggested that the addition of the word “further” was meant to convey a slightly more hawkish tone.”

Current pricing in interest rate derivatives markets, which enable investors to hedge against changes in interest rates and provide insight into investors’ expectations for monetary policy, suggests the market already expected an interest rate rise in March.

However, what is less certain is how many rate rises the Fed will manage in total this year. The same market pricing implies a three rate increases in 2018 when the Federal Reserve has room to announce a total of four, running at one every quarter.

“He was explicit in suggesting that market volatility would not derail the tightening cycle. A lesson we have learned well this month. And as he did in a similar speech almost a year ago, he also acknowledged the role of monetary policy rules, at least as a starting point for policy decisions,” says Michael Metcalfe, global head of macro strategy at State Street Global Markets.

“This will only reinforce that policy is on track to the neutral rate and perhaps beyond depending on the inflation path in the coming year.”

The concept of the “neutral rate” is an important one for the US Dollar at the moment. It refers to the interest rate at which Fed monetary policy neither stimulates nor damages the economy.

It is important for the Dollar because, with US rates at 1.25% and the Fed’s latest estimate of the neutral rate at 2.75%, American rates can only go so much higher before they become destined to fall sooner or later.

There are many other central bank across the globe who are yet to commit to raising rates, meaning there is scope for interest rates to rise further elsewhere in the world than there is for rates to move higher in the US.

Diminishing upside to US rates, combined with a broad global economic pickup, has left the greenback playing second fiddle to other currencies of late and contributed to greatly to a digit losses for the Dollar index in the last 12 months.

It would take an increase in the Federal Reserve’s estimate of the neutral rate to engineer a meaningful rebound by the Dollar, which is down 12% against the Pound in the last 12 months and around 16% against the Euro.

This is why markets are so focussed on Powell’s tone toward the economy Tuesday. They are looking for signs that the Fed’s outlook for the economy is improving, in the hope this will boost its forecast of the long term interest rate for the US.

The Pound-to-Dollar rate was quoted 0.46% lower at 1.3898 during noon trading Tuesday, after having reversed an earlier 0.10% gain when Powell’s testimony was released, while the Euro-to-Dollar rate traded an equal earlier profit for a -0.38% loss when it was marked down to 1.2264.

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