As the countdown began for the first interest rate hike in almost a decade in what is setting up to be the historic event for the year, I am getting many questions on how high the dollar will rise after the hike, as if there is only one direction for the currency to go. It is rational that increasing interest rates from the world’s largest central bank will support the US currency as higher interest attract foreign investment especially when compared to other major central banks.
Although more than 83% of market participants expecting a rate hike tomorrow and economists are even setting a higher probability, the dollar is on the decline since beginning of December after the DXY traded above 100. This provides an indication that whoever was bullish on a December rate hike went long earlier in the year and now either holding position or sitting on the side-lines for more clarification on the future trajectory of Fed’s monetary policy.
Historic data indicate that three out of the past five tightening cycles the DXY declined as markets tend to price in a rate hike way before its triggered and traders follow the proverb "buy the rumours and sell the news” which is very likely to be the case scenario. From most recent occurrences, the Euro rallied after latest ECB meeting by more than 300 pips although the central bank extended it’s QE program and lowered deposit rates “Yes, markets were looking for more action”. The NZD is another currency that rallied last week after the central bank cut main interest rates.
The Fed expected dovish language would be another key reason for the dollar not to rally on the rate hike day. Recent turmoil in financial markets, mainly with oil prices heading to 2008 crisis levels will threaten policy makers towards reaching inflation targets and would require a very cautious approach reiterating that tightening cycle would be slow and gradual.
The dot chart, part of the FOMC's Summary of Economic Projections released along with the policy decision statement, is another key indicator to look at as it shows where each participant in the meeting thinks the fed funds rate should be at the short and long run. These dots were lowered repeatedly in past meetings and if December meeting pulled them further lower, this would provide a further indication of USD selloff on the decision date.
Chances of USD rally although slim but still possible
In financial markets you should not rule out any possible scenario, and in this case “US dollar rally occurring on the decision date.” This scenario might occur if Janet Yellen surprised with a less Dovish speech or the statement indicated further tightening in first quarter of 2016. You should also watch Janet Yellen’s press conference very carefully as she might provide a better indication of future fed plans.