How will the Fed hikes affect the USD?

December 2015 was the last time the Federal Reserve constricted the monetary policy. However, the monetary policy will change again in a couple of days when the U.S. central bank prepares to increase the interest rates for the first time in a year. Even though there have been a lot of changes this past year, one of the things that have not changed is that the announcements about monetary-policy are for larger market movers for currencies, which is of particular importance when a central bank is expected to make a significant policy change. A year ago, the Fed had been planning for its first time in a decade rate hike. The move this month is a lot less historically significant, although it is the first time there is a round of tightening in 12 months.

The main question is that if everyone expects that there will be a Fed increase in rates when they do rise, will the dollar rise or fall?

A rate hike has a positive impact on the currency. However, in this situation, the U.S. dollar reached multi-month highs ahead of the upcoming meeting with the fund futures of the Fed that shows the market pricing with a % chance of a hike. Everyone expects that the Fed will increase the interest rates. The question is if the U.S. dollar will rise or fall? The answer to this questions has ramifications for the forex market because the most recent moves with regards to the major currencies, such as the steep drop in the euro, Australian dollar, and the Japanese yen, have been steered by the U.S. dollar’s strength.

In December 2015, when there was a rise in the interest rates by the Fed, there was a little continuation before a sharp drop for the USD/JPY in a month to 116 from 123.57  and then to 111 in only two months. At this same time, the market price had a 75% chance of a hike instead of 100%.

Three different scenarios

There are three possible outcomes for the FOMC meeting in December. It is important to know why the Fed is prepared and ready to increase the rates. There have been talks in the Fed about an increase in rates for a while. Two of the members of the committee for policymaking, Mester and George, voted for an immediate hike in rates in November. The table below shows that there is a general improvement in the U.S economy during the meeting in November. From the table it is apparent that consumer spending and job growth and consumer prices are increasing, the unemployment rate dropped, and the housing market stays stable. In the third quarter, the GDP growth was strong, and it helped to drive the U.S. stocks to significant high. The improvements have led the Fed to worry about inflation in the future rising too quickly and to avoid this; there has been almost consistent hinting that there would be an increase in rates before the year-end.

The election of Donald Trump as U.S. president was a big game changer for the financial markets. Even though the U.S. stocks had been falling, the reversed and reached a high while the U.S. 10-year Treasury yields hit above 2% for the first time in the past 11 months. The USD hit a high of 5% in response, and the moves could impact the policy plans of the Fed due to the sharp increases in yields, and the strengthening of the dollar tightens the economy while it was increasing the borrowing costs and makes exporting more expensive. Namely, the most recent changes in the financial markets do play a part in the work of the Fed by decreasing the pressure to raise the interest rates and again shortly after. All this means that there is a chance for another rate hike in December, according to the futures of the Fed Fund, which does not exceed 50% until June 2017. For Janet Yellen, this is also the last chance to tighten before Trump becomes president, as Donald Trump has often been quoted that he would replace her and will try to put pressure on the central bank.

There is no 25bp hike expected until at the earliest June 2017, by investors after the December hike.

How the FOMC rate decision is going to impact the U.S. dollar, it is not expected for the USD to have a significant reaction to the decision with regards to the rates, unless there is a surprise by the Fed for a 50bp hike or if it forgoes increasing the interest rates altogether. These two scenarios are highly unlikely. The biggest influences will be the dot-plot forecast and the forward guidance of Janet Yellen. In September, the presidents of the Fed looked at a 50bps of tightening in the next year. Therefore, if the plot indicated the expectations of more than two rate increases in 2017, the dollar can then rise. If it then holds steady with two hikes, the dollar may fall.

3 scenarios

Scenario 1 – Fed increases, Zero forward guidance provided by Yellen

If the Fed increases interest rates and if Yellen gives no insight as to when the rates are going to increase again, the USD should fall. Depending on how quickly the USD has appreciated during the past month, the profit taking is very overdue. Part of this move is attributed to Donald Trump’s spending plans. The structuring of the program and having it passed by Congress can take a lot longer that he expects. The eventual package could be a lot less impressive while the Senate members worry about the costs of financing. Therefore, if Janet Yellen fails to convince the markets that the rates can increase again in the first quarter, there is a forecast for a 1-2 percent correction for the dollar in the days afterwards.

Scenario 2 – Fed increases, Long break signalled by Yellen

If the Fed increases the interest rates and Yellen speaks about the impact of the increasing yields and/or confirms that any future rate increases could be dependent on the data, which may mean that she is not committing to any moves in the futures, the dollar could fall, and it would be more aggressive than in scenario 1. The taking of profit into the year-end is not unusual, precisely following the big moves that have been seen during the past month. In this scenario, there will be a continuation and the selling of the dollar – even as it drops it should be a successful trade. The strongest moves are expected from the USD/JPY and the EUR/USD pairs. These two currencies pairs fluctuate the most on the strength of the U.S. dollar. In this scenario, all currencies rise against the dollar.

Scenario 3 – Fed increase, emphasis by Yellen of the need for more tightening

If there is a Fed increase in interest rates and Yellen expresses her optimism with regards to the economy, this raises concerns about the rise in inflation, and it emphasises the need for extra tightening, the USD will rise. The Fed fund futures shows that unambiguous threatening and guidance that is strong forward is unexpected, there should be a multi-day or even multi-week continuation.

However, at the end of the day, the FOMC meeting in December could prove a big disappointment with regards to volatility in the market. There have been many opportunities for investors to prepare themselves for this move. The most likely scenario is number 1 as the yields increased and the Fed needs the time to be able to see exactly how much of a fiscal stimulus the Trump administration will provide. Yellen does not want to commit to anything, the dollar bulls could be disappointed, which will give investors a good reason for them to take profits on the long-dollar positions into the end of the year. All this does not mean that the dollar rally is over, but instead, there should be more of two-way demand.