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Friday February 19, 2010 - 17:42:30 GMT
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Dollar Soars after Fed Hikes Discount Rate

The Federal Reserve hiked the discount rate 25 basis points to 75 basis points late Thursday, sending the U.S. Dollar sharply higher. This buying spree spilled over into the overnight trade pushing the Dollar Index closer to the all-important major 50% level at 82.63.

 

The discount rate hike by the Fed was implemented to encourage banks to borrow more from the private sector. This move does not reflect a change in monetary policy despite market reactions and analyst commentaries to the contrary.  Some have interpreted the action by the Fed as a move towards monetary-policy normalization although the Fed insists this is not the case. As far as the Fed is concerned, its official statement is that interest rates will remain low for an “extended period”.

 

What it could mean is that the Fed is comfortable enough to begin hiking rates although it is not a change in monetary policy. In addition, I think it sends a clear signal that the emergency supply of liquidity that helped fund the economic recovery is done. It could also be interpreted as a psychological move by the Fed for investors to get ready for the future course of monetary policy.  This action by the Fed is basically signaling that future rates are more likely to go up, rather than stabilize or go down.

 

Some are calling the move by the Fed a surprise.  The timing may have been a surprise, but a discount rate hike was mentioned twice by the Fed during the last two weeks. In Bernanke’s testimony to Congress on February 10th, he said the discount rate would have to be raised “before long”.  The FOMC minutes released on February 17th stated that a discount rate hike “would soon be appropriate”. As far as the timing is concerned, it looks as if the Fed wanted to separate the hike from its normal FOMC activities in order to emphasize that this hike was not a change in monetary policy.

 

The EUR USD plunged following the discount rate hike. The Euro is now taking hits from the improving U.S. economy, Fed activity and concerns about Greece sovereign debt.  Activity in the Greek financial markets is indicating the country may not be able to borrow unless it receives backing from the European Union. Technically, the Euro is currently testing a major .618 retracement level at 1.3483. 

 

Overnight the GBP USD broke through support at 1.5534, taking the market to a 9-month low.  The catalyst behind the break is the discount rate hike by the Fed and fiscal concerns. Investors are worried that the U.K. economy is falling too far behind the U.S. economy. Some feel the Bank of England is well behind the Fed. This is probably true as the Fed is beginning to withdraw stimulus measures while the BoE is still considering additional quantitative easing moves. At this time, the charts are indicating that downside risks are increasing.  Overnight, U.K. retail sales fell more than expected.  This is a sign of weak consumer demand.

 

The USD JPY is trading higher. The discount rate hike by the Fed took away Japan’s short-term interest rate advantage over the Dollar. This means the Yen is likely to become the preferred funding currency for carry trades.

 

The weaker Euro is triggering a strong rally in the USD CHF.  Traders are selling the Swiss Franc in anticipation of more intervention activity by the Swiss National Bank.

 

The rise in the Dollar triggered by the Fed’s discount rate hike is putting pressure on commodities such as gold and crude oil.  This is triggering a sell-off in commodity-linked currencies such as the Canadian Dollar, Australian Dollar and New Zealand Dollar. In addition, the Aussie and the Kiwi are feeling pressure because the rate hike weakened their yield advantage.

 

Although the Forex markets are reacting as if the Fed is tightening its monetary policy, the Fed insists it is still on course to keep interest rates low for an “extended period”. According to Fed Bank of St. Louis President James Bullard, speculation that interest rates will rise this year are “overblown”.  This could mean the rally in the Dollar may be an overreaction. Don’t be surprised if the Dollar gives back some of its overnight gains.

 

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