Where is the US Dollar heading after the Fed paved the way for a September cut?

Financial markets have been extremely volatile in the last couple of weeks, as all of a sudden, investors realized central bank officials still have the ability to surprise them.

After years of inaction, the Bank of Japan (BoJ) hiked interest rates by 15 basis points (bps), and Governor Kazuo Ueda delivered a hawkish speech in which he mentioned that interest rates were still “low.” The Japanese Yen (JPY) soared with the news and put the US Dollar under selling pressure, as the American currency was already struggling following a batch of weak macroeconomic figures that spurred concerns about growth in the world’s largest economy.

Nevertheless, the United States (US) economy kept proving resilient, and concerns faded. Back and forth in rate cut bets seem to have stabilized, and investors are looking for a first Federal Reserve (Fed) interest rate cut in September. As a result, the US Dollar spent most of August on the back foot, with the BoJ kick-starting the USD decline, but it is far from being the only one responsible.

Focus shifts from inflation to employment

The focus has been so long on inflation that sometimes speculative interest forgets that most central banks have dual mandates. Stable employment is the second leg in which the Fed’s mandate rests, and it has returned to the spotlight.

As Fed officials won confidence in the inflation rate returning to 2% – although clarifying that they are not still there – unemployment levels gained relevance. The latest Nonfarm Payrolls (NFP) report showed the Unemployment Rate rose to 4.3% in July, still below the long-run average of 5.7% but higher than the 3.7% low posted in January.

Chairman Jerome Powell and co had long ago explained that a low unemployment rate poised a risk to inflation, as high labor demand increases manpower costs. But the US economy has come to a point in which the labor market is no longer tight, while inflationary pressures continue to recede.

The Fed statement from the July meeting included a critical change in the wording, as policymakers now believe “job gains have moderated” from the previous “have remained strong.”  Officials also remarked that the unemployment rate “has moved up” but added that it remains low. It’s worth clarifying that when the meeting took place, the latest official unemployment figure stood at 4.1%.

Policymakers pave the way for a September cut

In the press conference that followed the latest Fed’s decision, Powell said a rate cut in September is “on the table” and added that recent data suggest a “normalizing labor market.” His shifts towards a more dovish stance encouraged investors to bet on a 50-basis-points (bps) interest-rate cut in September, despite Powell saying it is quite unlikely.

At the time being, odds for a 50 bps rate cut stand at 32.5%, while 67.5% foresee a 25 bps trim, according to the CME FedWatch Tool.

But Powell was not alone. President of the Federal Reserve Bank of Atlanta Raphael Bostic said he is open to an interest rate cut in September as the US central bank can’t “afford to be late” to ease monetary policy amid signs of cooling in the labour market. Also, the well-known hawk, Minneapolis Fed President Neel Kashkari, said that the balance of risk has shifted, adding that “the  debate about potentially cutting rates in September is an appropriate one to have.”

At this point, it seems there won’t be any surprises from the Fed when it meets next month. But is that so?

Fears of a potential recession have fueled speculation for a loosen monetary policy. However, as said before, the US economy has proved resilient.

The US Gross Domestic Product (GDP) expanded at an annual rate of 2.8% in the second quarter of the year, according to preliminary estimates from the US Bureau of Economic Analysis. The reading followed the 1.4% growth recorded in the first quarter and came in above the market expectation of 2%.

The accompanying report showed that “The increase in real GDP primarily reflected increases in consumer spending, private inventory investment, and nonresidential fixed investment. Imports, which are a subtraction in the calculation of GDP, increased.”

Beyond relatively healthy growth, the unemployment level is below average, while inflation is barely above the central bank’s goal.

The case for a rate cut in September is not as solid as investors believe. There are more chances that Fed officials choose to trim rates to catch up with its pairs than because of the economic situation, as at this point, most major central banks have already proceeded with interest-rate cuts.

US Dollar Forecast and Potential Scenarios

Generally speaking, economic progress results in a stronger currency. Yet interest rate cuts tend to have the opposite effect, weakening the currency. But even if the Fed delivers, fireworks may be missing. 

Market players have already priced in a rate cut. The only “uncertainty” is if it will be by 50 or 25 bps.  Should the Fed refrain from touching interest rates, the Dollar would likely soar, while a 50 bps cut could have the opposite result. A 25 bps cut could spur some intraday action but will not be a game-changer.

The US Dollar Index trades at its lowest since early January, just above 101.31, the year low posted in August. A slide towards the 100.00 threshold seems likely as expectations of a rate cut mount, while a break below the level will confirm a longer-term bearish trend. A recovery of the index will depend on whether it’s able to regain the 102.00 mark, with the scope then to test 103.15.