The Fed Rate Hike and What it Means for the Markets: Pound US Dollar (GBP/USD) News

Pound Dips but there are No Surprises from America’s Central Bank as it Hikes Rates in Line with Dot Plot

With the Federal Reserve sticking to its ‘dot plot’ plan of raising interest rates and delivering another 25 basis point hike, what are the effects on other currencies and what will happen when the fabled ‘neutral’ rate is breached? Here, we consider what happened and what might happen next.

And so – as expected – the US Federal Reserve on Wednesday bumped up US interest rates by 25 basis points, meaning they now stand at 2.25%.

Although markets had been expecting this for some time, the move nevertheless caused some volatility on the currency markets with the Pound dropping 0.4% against the US Dollar (GBP/USD) almost immediately after the open. The Dollar was also up against most other major peers, including a 0.3% rise against the Euro.

The cause of this rise has been put down not to the rate hike itself, but the accompanying forward guidance note. Fed Chair Jerome Powell continued to signal continued ‘further gradual’ rate hikes, although he did not indicate a deviance from the path the Fed had already set itself upon for the next couple of years. This path shows an eventual peak of 3.25 – 3.50% in 2021, with the break-out ‘neutral’ rate being achieved some time in 2019.

Traders were quick to seize on the fact the word ‘accommodative’ was missing from the accompanying forward guidance press release as further evidence that the Fed was continuing speed up its tightening of monetary policy after a decade of ‘easy money’.

Neutral Interest rates: Crossing the Threshold

The ‘neutral’ interest rate is a crucial threshold where the rate achieves parity with the official rate of inflation – meaning the cost of borrowing money becomes neutral in real terms, in contrast to the ‘positive’ cost for the past decade where borrowers were effectively ‘paid’ to borrow.

Once parity is achieved there are likely to be a number of significant effects. Since the financial crisis of 2008 the supply of ‘easy money’ from the Fed and other central banks has permitted corporations to buy back their own stock, inflating share prices and the stock markets in general.

Furthermore, dollar-denominated loans have been taken out across the world by so-called emerging markets at negligible rates on interest. As the Fed continues to tighten its monetary policy, both raising interest rates and selling the assets that it has acquired through its liquidity programmes such as QE, the effect on markets and currencies will be marked.

With emerging markets from Turkey to Argentina already finding it hard or even impossible to pay back their Dollar loans in the face of their own currencies’ plunging relative to the ‘Greenback’, further rate hikes form the Fed and an end to stimulus measures will only serve to worsen the pain.

Divergence is the Name of the Game as Fed Rate Hikes Continue

So, with US rates now standing at 2.25%, we are beginning to see some considerable divergence from rates elsewhere. As a reminder, UK rates stand at 0.75%, Eurozone rates are still stuck at zero, while in Japan they are set below zero, at -0.1%. Other industrialised countries have similarly low rates, such as Sweden with its -0.5% cost of borrowing.

The effect of this – all other things being equal – will be a gradual strengthening of USD against its currency rivals. Money flows to where it is treated best, and if that means sitting safely and earning interest in a US bank account, then Pounds, Yen, Euros and Rands will be lining up to be converted into Dollars, with obvious downside effects on the exchange rates of these currencies.

But ‘all other things’ are rarely equal, and in the case of USD one could even claim that they are never equal. This is due to the fact that USD is the world’s reserve currency, and many commodities – including oil – are traded in it. Given that the ‘Buck’ enjoys this status, the Fed is able to create new money at the push of a button without the fear of creating runaway inflation – effectively it exports its inflation to other countries.

But for how long can this situation continue?

Trump’s Trade Policies and the Risks of Contagion

Another outlier for the US currency is the possibility that President Trump may actually favour a weaker Dollar. He has dropped hints about this in the past – always hastily retracted – but a weaker Dollar, while being politically difficult, would make US exports cheaper on the world market, even if it had the opposite effect on imports. This would be a handy weapon in a trade war.

With commentators warning that Trump’s belligerent trade policies are likely to spark a global trade war, a weaker Dollar could be one thing to look out for, even if the US central bank hikes rates past the neutral level. This could happen if foreign countries dump their holdings of US Treasury bonds and pull their holdings in Wall Street.

Trump, it is known, is no fan of hiking interest rates, and with the privately-owned Fed falling outside his control it is not clear how any possible ‘weaker Dollar’ policy could be enacted.

Returning to the immediate issue of the Fed’s rate hike ‘dot plot’, any further divergence from rates in the industrialised economies is likely to have knock-on effects not just for emerging market currencies, but also the commodity-linked currencies of Australia, New Zealand and South Africa, as well as the developed G7 as a whole.

With falling levels of economic growth in the Eurozone and elsewhere, analysts say that tightening monetary policy into the contraction phase of the larger business cycle is likely to further exacerbate the situation, leading to a serious fall in demand for exports. While the US economy may be roaring ahead, with 3%+ levels of annual growth, other countries may be forced into raising interest rates to protect their currencies. But with economic growth stuck at anaemic levels, increasing the cost of borrowing for businesses and individuals risks tipping entire regions into recession.

What this Means for the Pound US Dollar (GBP/USD) Exchange Rate

With Sterling still under pressure from all the political uncertainty surrounding Brexit, GBP/USD remains at depressed levels compared to before the EU referendum vote. Nevertheless, of the G7 economies, Britain is in second when ranked by interest rate levels. And with the bank of England refusing to rule out another UK rate hike there is ample scope for the UK currency to appreciate against the US Dollar.

As it stands, Fed Chair Jerome Powell is saying to expect another rate hike later this year, and a possible three more in 2019, although his outlook remains ambiguous. Asked about the economic prospects of the US in the face of a possible trade war with China, Powell replied that although he saw the US economy as being strong he conceded that it may be slowing and that the Fed would have to ‘reassess’ its rate hike policy in the next 12 months.

Such mixed messages from the Fed chief will no doubt keep traders on their toes for some time to come.

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Adam Solomon

Adam joined the team at TorFX soon after graduating from University in 2005 with a degree in Journalism. Since then Adam has advanced to become both Head of Trading and Head of Treasury. His keen interest in the currency market and knowledge of what drives exchange rates makes him perfectly positioned to produce regular market updates focused on the movements of the major currencies.

Contact Adam Solomon