Last Wednesday, on October 30th, the Fed announced that it will cut rates for the third time this year by another 25bps. The cut was in response to the most prevailing global topics, Trump’s trade war with China, a general slowdown in global economic growth, and uncertainty on Britain’s exit from the European Union. However, in contrast to the previous rate cuts, the tone was slightly less dovish than what we have recently seen. This suggests this may be the final cut in this round of stimulus.
Based on market expectations, the probability of a rate cut at the next Fed meeting has shifted- previously, the likelihood of a further cut in December was priced in at ~24%, however this has now fallen to 10%. This means that we do not expect further cuts in 2019. However, the likelihood of more rate cuts in 2020 is relatively high. The chart below shows that there is 45% probability of a rate cut by March next year. However, the Fed has announced that they would only consider tightening monetary policy if there is inflationary pressure beyond 2%.
As we have mentioned previously, the USD has been driven by a few main factors- the relatively higher interest rate environment, less uncertainty on the horizon, and the perceptions of a ‘safe-haven’ status in crisis scenarios. Recent economic data out of the US is mixed with unemployment figures at its lowest level in 50 years, but factors such as wage and economic growth are showing restraint which could encourage the Fed to stimulate the economy.
Typically we would expect monetary policy changes to have an effect on the economy two quarters after implementation. Therefore, we have anticipated the following scenarios and how they will affect the valuation of the greenback:
(i) Inflation goes beyond the 2% target and the Fed raises rates. Given that the market is pricing in rate cuts rather than rate hikes, this would mean that there will be an overall bullish USD run based on the structural change of a growing economy. We would expect to see capital flows to the USD pushing a strong depreciation in EURUSD.
(ii) Inflation does not cross the 2% target, but Fed holds still on rates. This is a neutral scenario where EURUSD would remain in a range between EURUSD 1.12 and 1.10. Any spikes in volatility would be driven by geopolitical and fundamental changes that will shift rate expectation accordingly.
(iii) Inflation fails to pick up and the Fed cuts rates. This case would be a major bearish scenario for the dollar vs. other major pairs. We would expect to see a trend reversal in Purchasing Power Parity (PPP) valuations beyond fair value. This potential outcome is associated with the most downside risk to the greenback. The chart below shows that EURUSD is considerably undervalued, by 11.8%. As such, inflationary valuation would suggest that EURUSD spot would converge closer to 1.25.
While there is a likelihood the USD rallies if inflation crosses the 2% threshold and as such, the Fed shifts to a more hawkish stance, we believe that the more likely outcome is a downward correction in the USD. This view is based on current fundamentals, fair valuations and the expectations of further rate cuts in the medium term. As FX advisors, we encourage our EUR denominated clients with significant exposures in the US market to evaluate the value at risk in their assets and calibrate their strategies accordingly.