The Post-Federal Reserve Retracement of the US Dollar Explained

The pen maybe mightier than the sword, but after yesterday’s retracement post-FOMC is anything but mightier than the dollar.

We have seen the dollar surge over the last few months as the U.S. economy shows signs of growth whilst others slump. With competitive devaluations of currencies worldwide against the dollar, all eyes were fixed on Wednesday's FOMC for any hints as to at least a respite in this dollar strength.

The Federal Market Committee finally dropped the word ‘PATIENCE’ raising the possibility of its first rate hike in almost 10 years. However, Yellen stressed in the press conference that the FED were not in any rush to raise rates. “Just because we removed the word patient from the statement doesn’t mean that we’re going to be impatient,” she said.

This saw the market expectation of a rate rise before December drop to less than 50 per cent, yet by yesterday afternoon we had regained all the losses and more incurred by the dollar post-FOMC. This may not sound much, but bear in mind the EUR/USD was 1.0658 when the FOMC made the announcement and it rallied in 2 hours to a high of 1.1043, a move of over 3.6%.

The FOMC lowered their median estimate for the FED fund rate for the end of 2015 to 0.625% compared with 1.125% 3 months before. Yet the dollar has rebounded again and it would appear that Federal Reserve Officials are finding it harder than they thought to decouple U.S. monetary policy from the rest of the world.

Is it possible that with every other central bank in the world cutting rates it has made the FED rethink their plans to go it alone? Michael Feroli, Chief U.S. Economist at JPMorgan Chase, said yesterday on Bloomberg TV, “It was hard to justify that kind of revision based simply on the economics, It does look like there was something else seeping in there. I’m sure the dollar was a factor.”

The strength of the dollar affects the US economy in 2 major areas:

1) Holding back economic growth by reducing the competitiveness of U.S. exports

2) Import prices are low due to the strength of the dollar which in turn depresses inflation.

This has the knock on effect of actually reducing the need to hike rates, so is this just jaw- boning from the FED to weaken the dollar? Yellen actually highlighted this in her press conference, saying that exports would be a “notable drag” on growth this year and tying that to the strength of the dollar, which she said partly reflected the strength of the U.S. economy. Yellen said the currency’s rise was also “holding down import prices and, at least on a transitory basis at this point, pushing inflation down.”

It would appear that the FED is worried about what will happen to the dollar and financial markets. US stocks sold off again yesterday on prospects of a rate rise, even if less than expected, but the dollar is obviously on hold while the market digests the price action going into the end of the week. Having seen a rally in the dollar index of 25% since July 2014 it is due for some correction, but with weakness in Europe and other major economies the comments from Yellen regarding the underlying strength of the U.S. economy may see the dollar continue on its upward trajectory. With comments from the FED Governor, “We continue to project above-trend growth.

We continue to project improvement in the labor market.” and "While the dollar’s rise is acting as a drag on growth, other forces are boosting it, including the steep drop in energy prices," they may have to find a way to tackle the ongoing strength of the dollar and to counter the rest of the world driving their currencies lower to keep their goods competitive. Yellen has now made it clear that she will take dollar strength into account when deciding future rate strategy and after yesterday’s price action in the dollar it looks like the market is going to test her resolve.

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