The Dollar Has Dropped to a Nine-month Low on Expectations of a Dovish Fed Pivot
The dollar fell to a nine-month low against a basket of currencies on Thursday, despite the Federal Reserve's pledge to keep raising interest rates, with markets betting that the resulting economic headwinds will force the Fed to cut rates as early as this year.
Following the Fed decision on Wednesday, the dollar index fell 1% to 101.08 points, its lowest level since April 2022. Dollar index futures fell even further, to 100.957 points.
The central bank raised rates by only 25 basis points (bps), citing recent progress toward lowering inflation. However, Fed Chair Jerome Powell stated that inflation in the country remained high and that he was unsure how much further interest rates would need to be raised to alleviate price pressures.
However, markets appeared to interpret this as a sign that the Fed was close to reaching its peak interest rate during this hiking cycle, with expectations for a potential dovish pivot by the Fed in the second half of the year increasing.
While the Fed is still expected to raise rates by 25 basis points in March, markets anticipate the Fed will then announce a moratorium on further rate hikes.
"With the economy losing momentum, the labor market showing tentative signs of cooling, and inflation on a downward path, we anticipate one final 25 basis point hike in March," ING analysts wrote in a note.
ING also pointed out that the Fed funds rate had finally risen above core PCE inflation, which was a "key metric" that the Fed had hoped to achieve. The investment bank now expects inflation to fall faster in the coming months. The core PCE price index in the United States was 4.4% in December, while the Fed's target rate is now 4.75%.
Traders in the interest rate swaps market appear to be pricing in at least a 50 basis point reduction in interest rates in the second half of the year, according to Bloomberg.
"Recessionary forces will then make the case for rate cuts later in the year," ING predicted, noting that economic growth, corporate funding, and the labor market are all expected to slow significantly further by the second half of 2023.
The possibility of a dovish shift weighed on the dollar. However, the dollar was weighed down by the strength of the euro and the British pound ahead of hawkish central bank meetings in both countries.
Both the European Central Bank and the Bank of England are expected to raise interest rates by 50 basis points later on Thursday and to signal further increases.