How will FED’s rate cuts impact the US dollar?

The Fed seems nailed on for a rate cut at the September 18^th meeting and many analysts do not think that it will make up for lost time by cutting rates 50-bps; a 25-bps cut should suffice. Of other developed-country central banks left to cut, only the Reserve Bank of Australia is being left behind, although we doubt that this will be for very long.

In theory, at least, we might have expected this foot-dragging by the Fed to lift the US dollar. After all, as others ease but the Fed stands firm, it increases the US’s rate advantage and, all else equal, might be expected to lift the US dollar. But the problem is that this ‘all else equal’ or ceteris paribus assumption, to use a common economist term, never holds. Things are changing all the time.

Hence economic studies that seemingly prove statistically that wider US rate differentials lift the US dollar do so under the assumption that other things are unchanged, and therefore cannot be relied upon. What’s more, rate differentials between the Fed and the likes of the ECB and BoE are still so small that it does not take much to happen elsewhere to render this differential meaningless. Perhaps only in the case of the yen, where the differential is so big, can the rate gap mostly dominate all else and so prove more useful as a guide to currency direction.

Steve Barrow, Head of Standard Bank G10 Strategy, said the significance of changes in US policy rates would be down to much more than mere rate differentials. This is because changes in US policy rates – and the US dollar – drive what we call the global financial cycle. Other central banks, notably the ECB, have a role to play in driving this cycle as well but international dollar dominance means that the Fed is the undisputed leader.

However, this financial cycle does not correspond with the monetary policy cycle for various reasons. One reason is that financial markets anticipate future policy change and this can start to ease global financial conditions even before the Fed has started to cut. And if the US dollar is inversely correlated to the financial cycle, as it mostly seems to be, then expectation of Fed easing can weaken the US dollar even before the Fed cuts and that’s exactly what we appear to have seen.

This, in turn, suggests that actual rate cuts from the Fed will only keep weighing on the dollar if the global financial cycle stays supportive. By this we mean that risk assets get stronger, like stocks, that credit spreads stay narrow, or even narrower and that liquidity strains do not emerge. In this environment the US dollar can fall even if the Fed is slow to the rate-cut party and even if it cuts rate by less than others.

However, there is another aspect to policy easing and the financial cycle that could give rise to a stronger US dollar. This is because financial conditions could tighten even if the Fed eases – and eases aggressively. For, as said earlier, the monetary and financial cycles are not in sync. For instance, the Fed’s prior tightening cycle might eventually prove to have been overkill, sending the economy into a hard landing and tightening financial conditions in the process.

Undoubtedly, some concerns along these lines exit already and, if they are borne out in coming months, the US dollar will likely rise. So, for now, Steve Barrow  thinks that the US dollar rather sits in the middle ground; potentially undermined by Fed rate cuts but also potentially supported should prior tightening crater the economy and tighten financial conditions. Perhaps the ‘all-clear’ on a more significant and sustained US dollar slide will only come when it is clear that the economy is out of the woods; that prior policy tightening won’t cause a recession.

However, Steve Barrow said we would not know this for some time and, just to destroy the ceteris paribus condition a little bit more, there’s also the huge disruption of the US election in November to come. In short, while we are longer-term US dollar bears, we are not getting carried away just because the Fed is finally turning up at the party.