June 20, 2019

How the Rest of World Reads the Fed

All eyes focused this week on the Federal Reserve Bank, as the market already had discounted at least two rate cuts by the end of this year. Despite signs of weakening economic growth and low inflation, Chairman Jerome Powell had previously insisted that the weak U.S. inflation was ''transitory'' and refused to cut rates. During this week's policy meeting, however, the Fed at last cited ''uncertainties'' in the economy, opening the door to easing for the first time in more than a decade. The U.S. dollar in general weakened on this headline.

While the next questions are when and by how much the Fed will cut rates, other central banks around the world have already reacted even before this week's Fed announcement.

In Europe, with no signs of inflation hitting its target, the European Central Bank has become more nervous. Last week, ECB President Mario Draghi said that an additional stimulus such as asset purchases (quantitative easing) may be needed, putting pressure the euro and Eastern European currencies such as the Hungarian forint, Czech koruna and Poland zloty.

In the UK, the Bank of England's monetary policy continues to be neutral as the fate and impact of Brexit are awaited. But the process of the United Kingdom's withdrawal from the European Union is becoming increasingly twisted with hard-Brexiter proponent Boris Johnson leading the polls to become the next Conservative Party leader. The British pound sterling has continued to slide as Johnson's popularity has increased.

Meanwhile in Asia, central bankers may feel relieved to see the Fed soften its stance on rates. With trade tensions and the Chinese economy no longer serving as an anchor for Asia, the business climate in Asian nations has become foggier. The dovish Fed tone has not only made interest rate differentials more favorable for the Asian currencies, but also relieves some of the heavy USD-denominated debt burden, giving a breather for these economies. Consequently, these Asian currencies have remained stable.

Finally, in Latin America, contrary to the rest of the world, these countries have been fighting to control inflation. The central banks there had been raising interest rates aggressively last year to stop their currencies from falling further. Their efforts have started to reap benefits this year. Now with the dovish Fed, the interest rate differential further favors these currencies. Latin American currencies have actually outperformed the U.S. dollar since the beginning of this year.

My View: Interest rate differentials play a major role in foreign exchange. While the dovish Fed this week opens the door for other central banks to ease their monetary policies, as the Fed had raised rates four times 2018, there's room for U.S. rates to fall faster going ahead. This would put further pressure on the U.S. dollar and therefore we are now expecting the U.S. dollar to gradually weaken in coming months.

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