Market Overview

11 March 2020

The Dollar Has Put on Weight Since Monday but Markets Are Keeping the Next Sharp Fed Rate Cut in Mind

Most investors have went long out of shares into cash, seeking shelter in a contradictory choice among safer assets. It's as if they are now trying to sail through a narrow strait with Scylla on one side, who is small but may provide returns on government and corporate bonds in various jurisdictions, and Charybdis on the other side who represents all possible risks and benefits of currency fluctuations.

The US Dollar has noticeably lost its weight over the past two weeks, especially after the Federal Reserve (Fed) decided to cut its interest rates urgently by 0.5 percentage points to 1.25% on March 3 and the benchmark ten-year Treasury's yield dropped more than twice to its present 0.5%-0.7% range.

But over the past two days the Dollar revenged the basket of major currencies. That has most likely happened due to the lower exchange rate effect which has made US bonds purchases relatively more profitable and partially offset the loss from the close to zero coupon yield. This may work in cases where investors who expect the Dollar to gradually return to its previous high levels in the long term. They may take into account the positive difference in interest rates between the US and European government bonds which is rapidly decreasing, but formally remains in favour of the US currency because the bond yields are negative in core EU countries.

However, this process of transferring limited portions of money flows to US assets with a guaranteed low income is likely to be restrained by expectations of a new radical rate cut by the Fed during its meeting on March 18. According to futures contracts data from the Chicago Mercantile Exchange (CME) the markets are expecting the US monetary regulator to cut interest rates by at least 0.5 percentage point after its emergency easing which has already taken place. More than 25% of investors bet on a rate cut of 75 basis points or even 100 basis points, considering that the Fed could take maximum advantage of the virus outbreak to refinance the US public debt and to weaken the Dollar amid trade battles.

Today and on Thursday, the US statistical agencies are expected to release reports on consumer price indices (CPI) and producer price indices (PPI). This data would have a significant impact on the Fed's decision at any other time, but not now when investors are not interested in almost anything except the authorities' reaction to the novel virus. US President Donald Trump said on Tuesday that he will ask the Congress for a payroll tax cut and other "very major" stimulus moves. Donald Trump and Vice President Mike Pence held a press conference in a very calm and convincing manner but the details concerning the tax stimulus program remain unclear, as they have yet to be tested by bipartisan Congress, which is not eager to cooperate. "It is too early to say the [stock] market sentiment has turned positive. Yesterday's rebound in the Dollar and in risk assets is a type of a rebound you often see in a downtrend," said Shinji Ishimaru, senior currency analyst at MUFG Bank.

It is not clear if a sharp Fed move next week may immediately boost investors' risk tolerance amid the drop in equities that have followed the first Fed's surprising rate cut this year. But that will surely diminish the US bond yield advantage over other similar instruments denominated in other major currencies. As a result, the assets linked to the Euro and to other US Dollar competitors may already benefit from such expectations only. Even the present fickle sentiment may push up not only EUR/USD to 1.15 and higher, but perhaps also help other major currencies like the Aussie and the UK Pound to strengthen against the Greenback.

At the same time, the possibility of a rise in the Australian currency is limited while the country is suffering from stalling trade as its major trading partner is China. The British Pound is still pressured by EU-UK post-Brexit negotiations. In addition, the Bank of England (BoE) also cut its key rate by 50 basis points to 0.25% on Wednesday, aiming to support the economy. This is a new downside factor for the British currency. However, after the Pound fell to $1.2827 from $1.2937 just before the announcement about the rate cut was made, it quickly recovered to the broader 1.2880-1.2950 area. The absence of a hefty negative reaction to the BoE's rate cut decision might be easily explained both by expectations of even more aggressive actions by the Fed and by a package of tax incentives by the BoE for small and medium-sized enterprises.

In this regard, the movements in the British Pound and in the Australian Dollar may be more complicated even after the likelihood that the Fed will cut interest rates. The European central bank (ECB) doesn't have much of a choice at its meeting next Thursday. The ECB doesn't have any more space for significant rate cuts, it can only lower them within the 0.1% or 0.2% range, and they cannot add anything further to the existing monetary stimulus. It might not be good news for the European economy but a very encouraging reason for market investors to hold, or maybe even buy, more Euro-denominated bonds. Playing on the contrast of monetary policies between the ECB and the Fed may make the EUR/USD the liveliest and most interesting instrument over the next coming weeks.


Analysis and opinions provided herein are intended solely for informational and educational purposes and don't represent a recommendation or investment advice by TeleTrade.

Indiscriminate reliance on illustrative or informational materials may lead to losses.

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