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Fed Passes on Rate Cuts, Leaves Scope for Dollar Rally

Tuesday, 21 August 2007 17:29:24 GMT  |  David Rodriguez, Currency Analyst

Forex markets sent the US dollar slightly lower on the day, as a sizeable drop in domestic Treasury yields increased the attractiveness of major foreign counterparts. A highly anticipated meeting between Fed Chairman Ben Bernanke, Treasury Secretary Henry Paulson, and head of Senate Banking Committee Chris Dodd failed to cause the expected volatility across financial markets. Indeed, many analysts expected that the Federal Reserve would vote to cut the Fed Funds rate through the morning, but the disappointing inaction caused a relief rally across domestic interest rates.

The Euro inched slightly higher against the dollar, adding $.0010 to $1.3480. Yield-sensitive British Pound traders were unable to take advantage of falling US interest rates, with fresh fears over UK credit markets causing a flight to quality in the Sterling. The currency traded 40 points off to $1.9814 at time of writing. A similar dynamic led the Japanese Yen higher against the greenback, with the dollar losing ¥0.60 to ¥114.25.

Fresh economic developments were limited to the uneventful morning meeting between Fed, Treasury, and US Senate officials. The closed-door conference produced little in the way of worthwhile news, with the Senate’s Chris Dodd the only one of the three officials to make statements on the conclusion of the meeting. The legislator praised the Federal Reserve for its decision to cut the discount lending rate by 50 basis points last week, and he said that central bank vows to use all tools available to ease volatility across financial markets. Senator Dodd stopped short of suggesting that the bank would cut Fed Funds rates through the near term, however, and disappointed many stock market bulls that had hoped for earlier monetary policy accommodation.  

Market expectations for an imminent Fed rate cut were significantly diminished on the morning inaction, lending the dollar some yield-linked support through afternoon trade. Interest rate futures contracts for September had previously priced in a 100 percent likelihood of a 25 basis point Fed cut through September, but a very significant correction on the day now leaves such expectations closer to 50 percent. This is a substantial turn in market sentiment, with such news very bullish for the US dollar through short term trade. On the one hand, markets remain sensitive to yield differentials across major currencies—directly improving the dollar’s stance against counterparts. On the other hand, Fed inaction may arguably lead to further risk aversion across financial asset classes—with the greenback one of the primary beneficiaries on overall market skittishness. Risk-linked assets showed signs of stabilization on the day, but outlook for the dollar will undoubtedly depend on whether this will continue through the near term.

The Dow Jones Industrial Average showed signs of weakness through the afternoon, with the disappointment on Fed interest rates leading to a modest tumble through time of writing. Domestic heavyweight stocks fell off of their morning heights, leaving the Dow a mere 13 points improved to 13,134. The S&P 500 was similarly mixed, adding 5 points to 1,450. Tech stocks were the largest gainers on the day, with the NASDAQ Composite rallying nearly 0.6 percent to 2,522.   

Risk aversion was nonetheless readily visible in domestic Treasuries, with the 2-year yield briefly dropping below the psychologically significant 4.00 percent mark. A later reversal in price left yields slightly higher, but the benchmark 10-year Treasury Note nonetheless lost two basis points to 4.61 percent.

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