USD continues to correct lower after Fed policy update

USD: A hawkish cut but door still left open for lower rates

The US dollar has continued to trade at weaker levels overnight following the sell-off in response to yesterday’s FOMC meeting. The US dollar index hit a low overnight at 98.537 after trading around the 99.000-level prior to the FOMC meeting. Similar price action was evident in the US rate market. The 2-year US Treasury yield remains round 6bps lower than prior to the FOMC meeting reflecting more confidence among market participants that the Fed will continue to gradually cut rates in the coming years. At last night’s FOMC meeting, the Fed lowered rates for the third consecutive meeting by 25bps. The decision was backed by nine out of the twelve voting members with three dissents. Of the three dissents, Fed Governor Miran voted again for a larger 50bps cut while there were two hawkish dissents from Kansas City Fed President Schmid and Chicago Fed President Goolsbee. There had been some concern that the number of hawkish dissents could have been even larger in the run up to the FOMC meeting. Yet it was still the largest number of dissents since September 2019 highlighting that the FOMC is becoming increasingly divided over setting policy. Furthermore, the updated DOT plot revealed that six FOMC participants would have preferred to leave rates on hold which likely included regional Fed Presidents Beth Hammack, Neel Kashkari and Lorie Logan who will become voting members next year. The soft dissents reinforce our view that it will become even harder to cut rates further at the start of next year.

In the updated statement, the Fed added “extent and timing” to the following guidance “In considering the extent and timing of additional adjustments to the target range for the federal funds rate, the Committee will carefully assess incoming data, the evolving outlook, and the balance of risks”. It was a repeat of the language used a year ago when the Fed paused their easing cycle for nine months. While we do not expect the rate pause to last as long next year, it supports our outlook for the Fed to keep rates on hold at least at the start of next year. The median projections for the Fed funds rates were left unchanged at 3.4% for 2026 and 3.1% for 2027 signalling the Fed is still planning for 25bps cuts in both years. The voting pattern for next year includes eight participants who favour two or more cuts which keeps alive market expectations for multiple cuts especially as a new Fed Chair will be appointed and will push for further rate cuts. In contrast, there were mainly only modest changes to the updated economic projections with growth revised higher, while inflation and the unemployment rate were revised lower. The biggest change was for economic growth next year which was revised up by 0.5ppt to 2.3% although that was likely due in part to weaker growth for Q4 of this year given disruption from the government shutdown thereby creating a more favourable base comparison, as well as the resilient consumer and data centre spending.  

In the press conference, Fed Chair Powell  stated that the economic outlook had not changed with the labour market gradually cooling. He added that downside risks to employment appear to have risen recently. The Fed believes that employment growth is weaker than officially reported which may overstate monthly job growth by 60k in recent months. He expects recent rate cuts to help stabilize the labour market. After recent rate cuts, he believes that Fed is well positioned to wait and see how the economy evolves at the start of next year allowing them to better assess whether they need to further calibrate the policy stance. He highlighted that the policy rate is now within the range of plausible estimates for the neutral rate. Another important point was that he expressed more optimism over productivity growth which has been structurally higher for several years now. If stronger productivity growth is sustained it could allow the US economy to grow more strongly without creating inflation pressures thereby leaving room for the Fed to continue gradually lowering rates.

The other main development overnight was the annoucement from the Fed that it will begin increasing purchases of Treasury bills (or, if needed, of Treasury securities with remaining maturities of 3 years or less) to maintain an ample level of reserves. The size of the Reserve Management Purchases (RMPs) will be sized to accommodate the projected trend growth in the demand for Federal Reserve liabilities as well as seasonal fluctuations. Monthly purchases will start off at around USD40 billion from 12^th December and are expected to remain elevated for a few months to offset expected large increases in non-reserve liabilities in April. After which, the pace of monthly purchases is expected to slow significantly. While the increase in short-term US Treasury bills is a technical development that will increase the asset side of the Fed’s balance and do not represent renewed quantitative easing related to monetary policy, the easing of US dollar liquidity conditions could be viewed as a negative for the US dollar in the coming months when purchases are elevated.

Overall, the Fed’s policy update does not change our view that the Fed will deliver further rate cuts next year although the timing of the next cut may be delayed until the new Fed chair is in place after May. Our latest US dollar forecasts (click here) expect a more stable US dollar at the start of next year followed by further weakness as the year progresses.                           

YIELD SPREADS CONTINUE MOVING AGAINST THE USD

Source: Bloomberg, Macrobond & MUFG GMR

KEY RELEASES AND EVENTS

Source: Bloomberg & Investing.com