Should you buy the US dollar amid the Fed delivering a 75bp rate hike?
- Fed hikes 75bp
- Goal is to have the funds rate 100bp above neutral
- More hikes to come
2022 appears to be the year of historic central banks’ decisions. After the European Central Bank (ECB) faced a daunting task last week, it followed up with an emergency meeting yesterday.
But markets had little or no time to digest what the emergency meeting was about, because the Federal Reserve’s decision in the United States loomed large. Up until Monday, the market expected a 50bp rate hike – as the Fed had suggested in the past.
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Yet, things turned dramatically, as an article in the Wall Street Journal, published on Monday, hinted that the Fed is considering a 75bp rate rise. Long story short, the Fed delivered a 75bp hike – the biggest interest rate rise in almost three decades.
Desperate times call for desperate measures.
Throughout the press conference, this was the main message coming out from the Fed. Uncertainty created by the war in Ukraine and the lockdowns in China makes it difficult for the Fed to forecast inflation.
Thus, it will do whatever is necessary to bring it down, and interest rates are just one tool they are willing to use extensively.
With this rate hike, the federal funds rate is now at 1.75%. Moreover, the Fed hinted that it will deliver another 50bp or 75bp rate hike in July, depending on the incoming data.
Therefore, by the end of July, the funds rate will be well over 2%. But is this enough to fight inflation?
More importantly – should you buy the US dollar on the Fed delivering the biggest interest rate hike in almost thirty years?
There is one saying among traders and investors, and that is to never fight the Fed. It may be behind the curve, but the interest rate differential, when compared to other central banks, is so big and rising that it is difficult to envision a weaker US dollar in the months ahead.
History tells us Fed will keep hiking
The Fed looks like it is in a race to tighten the policy. Judging by what history tells us, it should be.
One of the headlines that made rounds recently was a quote from the famed investor, Stanley Druckenmiller. He noted that throughout history, whenever inflation has risen by more than 5%, it never came down without the federal funds rate exceeding the CPI.
Well, US CPI has reached 8.6% YoY in May. Hence, the funds rate must rise way more for inflation to come down.
Fed delivers a strong commitment
Finally, the Fed delivered a serious message yesterday – a difficult one to ignore if you are thinking of shorting the US dollar. That is, it plans to have the funds rate above the neutral rate by about 100bp in the next two years.
For a proper understanding of what the Fed is really saying, let’s define the neutral rate. This is the rate, net of inflation, that ensures maximum employment.
It cannot be observed directly, but one can have an idea about the level by simply deducting the current inflation rate from the funds rate. By doing so, we see that the Fed plans to continue to tighten in the years ahead to reach its goal.
To sum up, yesterday’s message was pretty hawkish. If you add to it the fact that the Fed is also shrinking the balance sheet, then we have a bullish case for the US dollar that is difficult to underestimate.