The Federal Reserve concluded its two-day meeting yesterday. As was expected, the central bank lowered interest rates by 25 basis points to the range of between 2.0% and 2.25%. This was the first interest rate cut in more than a decade.
Instead of lowering the US dollar and boosting stocks, the rate cut led to a sharp jump on the US dollar and a sharp drop of US equities. The Dow lost more than 300 points while the Nasdaq and S&P 500 lost more than 100 and 30 points respectively. The dollar index rose to above 98.50 for the first time in more than a year.
There were a number of reasons for this market reaction. First, not all federal reserve officials came out in support of the 25-basis point rate cut. Eric Rosengren of the Federal Reserve Bank of Boston and Esther George of the Kansas City Fed voted against the rate cut. Instead, they voted to leave rates unchanged. They had good reasons for this. The US economy is in pretty good shape, with the unemployment rate at a 50-year low. The Fed said that the goal of the current rate cut was to protect the US economy from the weakness in Europe and Asia.
Second, the Fed said that the rate cut was a “mid-cycle adjustment to policy”, rather than a start of a more aggressive cycle of monetary easing. This means that the Fed might hold rates at the current level for a number of months. Previously, traders were expecting the Fed to signal one or two more rate cuts for the rest of the year. Still, the Fed said that it stood ready to “act as appropriate to sustain the expansion”.
In addition to the rate cut, the bank announced that it was stopping the quantitative tightening that has been going on. This is a process commonly known as shrinking of the balance sheet. This is after the Fed’s holdings of government-backed bonds swelled after the financial crisis. The QT process will end today.
The Federal Reserve is at a difficult place. While the US economy appears to be strong, there are signs of weakness around the world. Manufacturing activity has slumped as businesses navigate complex global issues. There is a trade war going on between China and US and between South Korea and Japan. In Europe, there are uncertainties on Brexit.
As a result, most central banks have taken a dovish tone. In Australia, the RBA has slashed interest rates two times. In the European Union, the ECB has pointed that it could reintroduce the quantitative easing and lower rates. In China, the PBOC has moved to boost stimulus to boost the economy. In the US, the Fed, especially the Fed chair, have been assailed by Donald Trump, who has accused them of working against his agenda. In response to the decision, the president said that:
What the Market wanted to hear from Jay Powell and the Federal Reserve was that this was the beginning of a lengthy and aggressive rate-cutting cycle which would keep pace with China. As usual, Powell let us down.
The chart below shows the reaction of the dollar index to Fed decision.
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