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Here’s what everyone is getting wrong about the likely direction of the US dollar after the latest Fed meeting

The greenback might be the new gold in a world of negative interest rates

PUBLISHED : Tuesday, 22 March, 2016, 1:17pm
UPDATED : Tuesday, 22 March, 2016, 1:17pm

“Don’t just do something, stand there,” was a quip oft-favoured by US President Ronald Reagan. The Federal Reserve arguably followed that line on March 16, dialing back their own forecasts for the extent of future US rate hikes.

Yet, even though the Fed’s statement was surprisingly dovish for markets, in comparison to monetary policy settings currently adopted by both the Bank of Japan (BOJ) and the European Central Bank (ECB), even a dove-like Fed appears taloned.

We may well at present be seeing the first stirrings of an increase in the inflation rate
Fed Vice-Chairman Stanley Fischer

Although the ECB may not “anticipate that it will be necessary to reduce rates further,” as its President Mario Draghi said on March 11, that comment only came after the euro zone’s central bank had already gone further into negative interest rate territory by cutting its deposit rate 10 basis points to minus 0.4 per cent.

Indeed, on Friday ECB Chief Economist Peter Praet took pains to assure markets that, notwithstanding Draghi’s comment, “a rate cut remains in our armoury” if needed.

As for the BOJ, while its own March 15 policy meeting stuck with its current minus 0.1 per cent interest rate applicable to one tier of reserves deposited with it by financial institutions, just one day later Governor Haruhiko Kuroda told Japan’s parliament that “there’s a possibility that we will decide to cut interest rates further.”

When asked if the BOJ could cut rates as far as minus 0.5 per cent, Kuroda responded that “theoretically, there is room to do so.”

So both the ECB and the BOJ currently remain committed to the use of negative interest rates even though the Bank for International Settlements (BIS), often referred to as the central banks’ central bank, has exhibited some concern about their impact.

“There is great uncertainty about the behaviour of individuals and institutions if rates were to decline further into negative territory or remain negative for a prolonged period,” the BIS wrote on March 6.

Meanwhile the Fed, as analysts at National Australia Bank put it, “collectively decided to lower the forecasts for policy tightening, removing two of the rate hikes it has previously been signalling for 2016.”

But that still leaves the Fed forecasting two US rate hikes yet to come in 2016 while monetary policy-setters in Frankfurt and Tokyo are still utilising negative interest rates.

It may also transpire that the US central bank morphs from dove to hawk if domestic inflation data continues higher and, though not reflected in the policy statement, Fed Vice-Chairman Stanley Fischer is already wondering if upward price pressures are building.

“We may well at present be seeing the first stirrings of an increase in the inflation rate,” Fischer said on March 7, adding that would be “something we would like to happen.”

Extrapolate Fischer’s overall position to the Fed as a whole and a dovish tone in the Fed’s March statement becomes more explicable, but that doesn’t rule out US rate setters taking a more hawkish approach in coming months. A June rate hike cannot be excluded if US inflation data continues to tick up.

Notably, US core inflation, a measure which excludes volatile food and fuel costs, rose 2.3 per cent in February on an annualised basis, the biggest rise since May 2012.

If that kind of data continues to emerge, market interest rates could edge higher anyway even if Fed Chief Janet Yellen currently believes the rise in US prices is driven by “transitory” factors and has not herself “yet concluded that we have seen any significant uptick that will be lasting in, for example, core inflation.”

Market moves aside, on a comparative basis that still either means the Fed, having raised rates once in December, continues to stand pat or hikes, while the BOJ and ECB are in negative territory.

Investors are therefore left having to make a judgement but perhaps might like to bear in mind BOJ Chief Kuroda’s view that “all other factors being equal, however, [a negative interest rate policy] works to weaken a country’s currency.”

With personnel change at the BOJ on March 31 that may produce a policymaking committee even more receptive to Kuroda’s agenda, moves by the BOJ further into negative interest rate territory should not be ruled out.

Markets may have been taken aback by the dovish tone of the Fed’s policy announcement and reacted accordingly but imagine if the euro zone, Japan and the United States were three horses running at Happy Valley Racecourse, with the ECB, BOJ and the Fed as the respective jockeys.

With the euro zone and Japan carrying weights in the form of negative interest rates wouldn’t the clever money back the United States even though the Fed itself had disappointed markets last time out?

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