US dollar strengthens after hawkish Fed pause (Daily analysis 21.09.2023)

The Federal Reserve kept interest rates at their highest range in 22 years of 5.25-5.50%. The decision announced on Wednesday is also the second pause in the hike cycle that began in March 2022. As in June, it is seen as a sign that US monetary policy intends to maintain a sharp, hawkish course. Above all: the door to a final hike at the next meeting scheduled on 1 November remained wide open. As a result, the EUR/USD pair has deepened last week's lows and is slipping towards 1.06.

A week ago, the ECB raised the deposit rate to a historic level of 4%, but the euro found no respite as a result of this move. Today, the Fed decided not to hike, yet the dollar is not depreciating. The key to investors' reaction, which is not obvious at first glance, lies in the latest macroeconomic projections. In Europe, growth estimates for the coming quarters have been lowered. In turn, FOMC members raised their expectations for the optimal interest rate level at the end of 2024 from 4.625 to 5.125%. At the same time, policymakers insist that an additional rate move in November is still possible. A gradually decelerating economy and ongoing disinflation could stand in the way of such an end to US monetary tightening.

The economic situation allows the Federal Open Market Committee to refrain from a twelfth upward move in the cost of money. US GDP growth is impressive, especially against an outlook of a Euroland that is teetering on the edge of recession. Inflation is gradually slowing; most notably, core prices in August were 4.3% higher than a year earlier. There are also signs of fading labour demand. In the past three months, employment grew by an average of less than 150,000 jobs. In the final straight of the cycle, having hiked rates by a total of 5.25 percentage points, the FOMC is, therefore, more comfortable with its decision-making than, for example, in the second half of last year, when the scale of one-off hikes reached 75 basis points three times.

Another not-insignificant factor may be that investors trusted the message coming from the Fed for several months. Hopes of a rapid retreat from a harsh, hawkish policy and an imminent cut in the cost of money were abandoned. In the second quarter, following the bankruptcy of several regional banks, the market was bracing itself for a sharp rate cut to be initiated later this year. At present, the market's valuation assumes that in twelve months, their level will still be around 5%. This translates into restrictive financial conditions, offering the prospect of containing inflation and preventing the emergence of dangerous imbalances, including in the re-emerging property market.

Once the Fed, ECB and other main central banks have reached their rate targets, trends in the currency market will be determined by global economic conditions, which have recently become significantly desynchronised. A resumption of the downward trend in the dollar's quotations will become most likely if GDP dynamics in Europe and China emerge from the bottom while the US economy deteriorates. We have been seeing the first early signs of this favourable scenario for emerging markets. A return of the dollar to the summer lows or a rebound of the EUR/USD pair to 1.10 is becoming a very distant prospect.