Forex report: Fed exit move boosts dollar

The Fed’s move after the end of trading on Thursday has sent the dollar surging and equities reeling. Neither event is likely to last while it may take several more reminders from Fed members before dollar bulls come to their senses.

Typically stock markets do react negatively to the onset of a tightening cycle before investors realize that rising interest rates are a sign of strengthening economic stamina. In this case, however, the Fed’s prompt action comes at a time when investors are still tossing coins to guess the outcome at fellow central bank meetings as to whether more quantitative easing is on the table. The elevation of the discount rate is the Fed’s polite way of telling money market bankers to “go fish” rather than continue to rely on its generous 28-day loan facilities put into place when the financial crisis slammed home. Market participants now have a new sport when it comes to FOMC day and will now have to judge where the new normal spread between fed funds and discount rate should be. During the spring expect a couple more moves towards normal.

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U.S. Dollar – Dollar bulls have the matador pinned against the edge of the ring today and are in no mood to stop charging. You have to look back to May 2009 to find a more valuable dollar against the euro, as the dollar index has jumped almost 1% in overnight trading. Traders who had favored the dollar recently have done so for several reasons. First, they accurately predicted that the Fed would be fastest to the exit when it came to doing away with emergency monetary stimulus measures. Second, they argued that economic growth would be faster to return to the U.S., which would increase the chances of quicker monetary tightening from the Fed than from other central bankers. Finally, the recent sovereign debt crisis is likely to linger, rewarding the dollar with a return to its traditional safe haven role.

Already two Fed speakers have voiced their perspectives on the technical measure. St. Louis chief Bullard said that market expectations for a 2010 rate rise are overblown. Meanwhile Atlanta’s Lockhart said the move doesn’t signal a tightening of policy. The typical spread between the discount and fed funds rate is about 1% and that was even the case when policy was relaxed after the tech-bubble burst right through 2003. The surge in the value of the dollar is having ramifications on both global yields and commodity prices.

Finally, watch for the S&P 500 index to finish the day higher despite a gloomy start. Investors are highly likely to get the Fed’s message and ultimately will revert to the recent buying of what they perceive to be an undervalued asset class.

Aussie dollar – The Aussie slipped by a cent at one point although is still higher on the week versus the dollar at 89.23. The common theory behind Aussie dollar weakness is that rising U.S. rates will erode the yield premium available on riskier currencies. In a parliamentary testimony today RBA Governor Glenn Stevens confessed that short term rates in Australia are perhaps 50-100 basis points below normal. The forward curve plays out such expectations and while it remains to be seen the full extent of what the RBA considers necessary, there are still further rate hikes coming out of the RBA.

Canadian dollar – The Canadian dollar has reversed its bullish path and looks troubled by the move from the Fed. One could argue that economic conditions look better in Canada than in the United States given the reliance of natural resource exports from the Fed. The loonie shed about a cent to 95.08 U.S. cents.

British pound – Sterling fell to a nine month low versus the U.S. dollar. The Bank of England downgraded its growth and inflation forecasts recently and has underwhelmed investors in an election year. Recent minutes revealed that although paused for now, the MPC might feel the urge to reinstate a bond purchase program in order to stimulate the economy. Up for discussion in recent history was the discussion of lowering the rate paid to money market banks who keep deposits with the Bank. By lowering the rate paid to those banks, the Bank of England felt that they might be encouraged to lend to each other rather than opting for the safety of holding money with the central bank. While that discussion has not since resurfaced it would be a move similar to what the Fed has announced in that it would be a step away from stimulus. The distinction here is that the Fed is trying to discourage a reliance on borrowing and the Bank of England is trying to encourage lending within the market. Although a policy option the Bank of England can’t bring itself to take the step probably because the economy is too weak.

Further evidence emerged of consumer weakness today when January’s retail sales fell by far more than was expected with a 1.2% monthly decline. An upward revision to December data helped improve the annual performance to a 2.6% year-over-year increase. The pound slumped to as low as $1.5350 before rebounding to $1.5409.

Euro – Still stunned by sovereign debt woes and the prospect of a further blow up in peripheral Eurozone government bond spreads, the euro slipped to $1.3450 this morning. Against the pound it rose to 87.71 pence while against the Japanese yen it declined to ¥124.00.

Japanese yen –The dollar traded above ¥92.00 for the first time in more than one month as investors were herded towards the dollar on yield premium arguments. The yen doesn’t look very clever even in desperate days of desperation in an environment of speculation even over technical monetary tools. The dollar eased some gains after inflation data this morning to stand at ¥97.71.

Andrew Wilkinson is a Senior Market Analyst at Interactive Brokers. ibanalyst@interactivebrokers.com

Note: The material presented in this commentary is provided for informational purposes only and is based upon information that is considered to be reliable. However, neither Interactive Brokers LLC nor its affiliates warrant its completeness, accuracy or adequacy and it should not be relied upon as such. Neither IB nor its affiliates are responsible for any errors or omissions or for results obtained from the use of this information. Past performance is not necessarily indicative of future results.

About the Author
Andrew Wilkinson

Andrew is a seasoned trader and commentator of global financial markets. He worked for several London-based banks trading cash and derivatives before moving to the U.S. to attend graduate school. Andrew re-joins Interactive Brokers following a two-year stretch at a major Wall Street broker-dealer as their Chief Economic Strategist. His coverage of stocks, options, futures, forex and bonds regularly surfaces in global media, and over the last several years Andrew has made many TV appearances on Bloomberg, BBC, CNBC and BNN and Yahoo Finance.

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