What will happen to the US dollar if FED cuts rates?

There are a number of reasons why Steve Barrow, Head of Standard Bank G10 Strategy thinks the Fed’s (likely) first cut this week in its easing cycle won’t move the US dollar substantially over time, even if there is a sharp initial reaction to the size of the cut.

The first is that the Fed is easing in line with other central banks, unlike its previous tightening cycle when it was on its own. It means that interest rate differentials won’t move materially. The only exception within G10 is the yen, where BoJ rate hikes are not only driving significant rate divergence but also leading to substantial volatility, as we saw when the BoJ last hiked at the end of July.

“We expect the yen to strengthen further against the US dollar and to remain volatile, but we believe that this will be part of general yen strength against other G10 currencies, not a part of general US dollar weakness,” said Steve Barrow.

A second factor is that the ability of easier Fed policy to stimulate risk assets, like equities, and so weigh on ‘safe’ assets like the US dollar, is limit  ed because asset prices are already quite elevated, presumably because Fed easing is already priced into the value of assets like stocks and bonds. Indeed, there is the risk of a short-term ‘sell the fact’ slide in risk assets, especially if the Fed opts for a 25- bps rate cut, and that could support the greenback.

And finally, Steve Barrow believes that the ability of Fed easing to influence the US dollar this year is stymied by the hugely uncertain US presidential election in November. It is not just that the US election outcome is tough to call; they usually are. But the visions offered by the candidates are hugely different and hence have the potential to create significant volatility when the result is known and so usurp any impact from the Fed’s monetary policy.

Putting all this in terms of euro/dollar, Steve Barrow suspected that the 1.05-1.10  range that has magnetised euro/dollar this year will continue to do so after the Fed has started to cut rates. Whether it will do so after the US President election is another matter. Up until, and possibly just after, the election the 1.05 end of this range could be in most in danger but, over the long haul we anticipate a decisive rise above 1.10 as the euro pushes on to the 1.20 region.

This might only appear to be modest weakness for the US dollar from current levels, although our sense is that euro/dollar may provide a misleading guide to US dollar weakness. The euro could struggle somewhat as the economy continues to languish, the ECB produces more easing than currently anticipated by the market, and political factors, such as the surge in far-right support continue to blight the political landscape. Hence currencies such as the yen and sterling are expected to make stronger gains against the dollar over the longer-term than we are likely to see from the euro.

This being said, there could emerge some short-term pressures on the pound that cause it to lose its status as the strongest G10 currency so far this year. Some of this strength seems to have been borne of economic optimism as growth has picked up and hopes were high that the incoming Labour government might boost it even more.

Steve Barrow suspected that growth would stumble, in part because government warnings of a tough budget at the end of October will likely cause some consumers and businesses to postpone or even cancel spending and investment decisions. On the monetary front as well, there could be some vulnerability. The Bank of England meets this week, a day after the Fed and, as things stand there are virtually no expectations for a second cut in base rates.

However, should the Fed cut rates 50-bps on Wednesday, speculation that this could put pressure on the BoE to deliver a rate cut on Thursday could weigh on the pound. And while the market currently ascribes virtually no possibility of a base rate cut on Thursday, Steve Barrow leans to the view that rates could come down again and, this too, makes us somewhat wary of the pound in the short-term even though he thinks its prospects are better over the long haul with forecasts for sterling/US dollar to rise to above 1.40 and for euro/sterling to head down towards 0.90.