Fed raised rates again, triggering volatility in Forex markets

As expected, the Federal Open Market Committee (FOMC, aka “The Fed”) continued its cycle of raising interest rates at the latest meeting on February 1. The increase was 25 basis points, taking the fed funds rate to 4.5-4.75%. Short-term interest rates are now at the highest level since 2007. In the post-meeting press conference, Chair Powell reiterated his commitment to tight monetary policy, saying, "Restoring price stability will likely require maintaining a restrictive stance for some time."

In late US trading after the Federal Open Market Committee (FOMC) news, the dollar initially dropped to a new low for the year, but over the next 24 hours, the dollar reversed course and moved higher. The rally accelerated on Friday, aided by a robust US jobs report.

What changed last week:

• The Fed raised rates for the eighth time since March 2022. The fed funds rate is now at 4.5-4.75%
• The US economy added 517,000 jobs in January, well above market analysts' expectations.
• The ISM (Institute for Supply Management) Services report showed unexpected strength in the services sector, more evidence of resilience in the US economy.

What's next for the dollar? The dollar had been trending lower for the last four months after hitting multi-year highs last fall. The downside momentum slowed in the last several weeks as the dollar tested important support levels. A "technical correction" was no surprise. The question now: "Is this the beginning of the next leg higher in the long-term dollar uptrend, or will the rally be short-lived?" The best way to get an answer may be to compare economic conditions in other countries to those in the US.

Europe:  Inflationary pressures have subsided as the Euro CPI came in lower than expected. The European Central Bank raised rates by 50 basis points, and President Lagarde said it is her "intention" to raise rates again by that amount in March. Markets appear to believe that the ECB is near the end of its tightening cycle as German bond yields dropped sharply. The IMF (International Monetary Fund) projects growth of 0.7% in 2023 for the entire eurozone.

Japan:  The IMF expects the Japanese economy to grow by 1.8% in 2023. Japan has resisted raising interest rates, but the current head of the BOJ will be retiring in April. The expectation is that his successor will bring Japan's monetary policy in closer alignment with the rest of the industrialized world. The yen has recovered substantially from multi-decade lows, but after a rally of nearly 15%, it may be ready to pull back,  especially if it appears that Japan will not move to raise rates in the spring.

Great Britain: The British economy expects to contract by 0.6% in 2023. The UK appears to be caught in a classic "stagflation" scenario as prices remain elevated despite interest rates hikes from zero to 4%. Britain is currently experiencing labor unrest as unions press for higher wages. After a rise of nearly 20% against the dollar, the pound may be due for weakness in the near future.

China:  The Chinese economy is expected to grow by 5.2% in 2023. Pent-up demand and the end of "Zero-COVID" policy are driving this forecast. Chinese manufacturing should return to normalcy, and domestic spending will likely increase to pre-pandemic levels. Commodity markets, particularly industrial metals, have risen sharply in anticipation. The yuan has risen recently and will most likely continue to strengthen.

Takeaways:  Fed Chair Powell reminded markets that the Fed "still has work to do," meaning that rates will likely increase in the coming months. Though other countries have raised rates, the dollar continues to enjoy an interest rate advantage over its rivals, which may be expressed in dollar strength this year. The IMF expects growth of 1.4% for the US in 2023.

Last week saw sharp declines in several emerging market currencies, notably the Pakistani rupee and the Lebanese pound. This is ongoing evidence of the fallout from a strong dollar. Maturing debt will need to be refinanced at much higher rates than a year ago, setting the stage for potential defaults that could trigger a global financial crisis. Most of the world would benefit from a weaker dollar, so there may be concerted central bank action to keep a lid on the greenback (Plaza Accord 2.0).

US debt levels are at all-time highs as the debt-to-GDP ratio has reached over 120%. It will cost more than ever to service this debt with recent increases in interest rates. Former buyers of US debt, particularly Japan and China, have been less willing to purchase US bonds. This will dampen demand for US assets and could put pressure on the dollar.

Foreign countries are exploring ways to circumvent the dollar as a means of international exchange. Russia and Saudi Arabia have expressed interest in accepting yuan as payment for oil. A lower dollar will likely result if other currencies begin supplanting the dollar's role in international trade.

In Summary:

It is impossible to predict where the dollar will go over the next few months. There could be a big rally if conditions are favorable (or chaotic). If the recent downtrend continues, it could lead to a significantly weaker dollar. Either way, currency markets will remain volatile, causing consternation for companies on the wrong side of the equation. Hedging that risk will be essential for businesses that want to thrive in an uncertain environment. Check with Pangea for a Forex risk assessment and hedging strategies to minimize the damage that FX volatility can do to your business.