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Thoughts on the global economy and FX markets

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US dollar remains funding currency of choice

Thu, Nov 5 2009, 09:11 GMT
by Mitul Kotecha

Econometer.org

Rate hikes in some countries including Australia and Norway and a general improvement in economic data had led to some expectations that the Fed would shift its rhetoric on monetary policy but in the event this was not to be the case. The key comment in the FOMC statement following the interest rate decision was that rates would be kept low for an “extended period”. The Fed added that its policy stance was contingent on “low rates of resource utilization, subdued inflation trends and stable inflation expectations.”

The fact that the Fed maintained its relatively dovish stance contrary to some expectations ahead of the FOMC meeting resulted in interest rate markets paring back expectations for future rate hikes though I still believe that a rate hike anytime in 2010 will prove premature. The Fed’s new conditions mean however, that the Fed will be more restricted when it does come to timing rate hikes and markets will watch closely, the unemployment rate and inflation expectations to determine this timing.

Given that the unemployment rate is still rising and is expected to decline only slowly over coming months whilst core inflation is set to decline further, and excess slack in the economy is only likely to be reduced gradually, markets are still too aggressive in looking for increases in interest rates next year. The Fed did not remove the reference to an “extended period” of low rates despite speculation ahead of the meeting and whilst many in the market continue to debate how long this will be, the Fed will not feel any need to rush to reverse policy.

The USD weakened following the FOMC meeting but did not suffer a particularly hard blow. Going forward the USD will not recover until there is clearer evidence that the Fed is ready to reverse policy and in the near term this means that the USD will remain under pressure, especially if markets push back expectations of rate hikes. This will mean that the USD will continue to be the funding currency of choice for several months yet. Cyclical USD recovery is still some way off but eventually the Fed’s actions will pay off and the USD will recover by around mid 2010 as the market becomes more aggressive in pricing in rate hikes in the US.

Published on  Thu, Nov 5 2009, 09:15 GMT