CHART: History says a US rate hike does not guarantee a stronger US dollar

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In just a week’s time the US Federal Reserve is expected to lift interest rates for the first time since June 2006.

The US dollar, up until recently, has been rallying hard as markets pre-empted the likelihood of the highly anticipated “rates liftoff” finally coming to fruition.

It’s now close to fully priced, not only by markets but also other major central banks who are clearly hoping it will continue to underpin US dollar gains, weakening their currencies as a result.

While from a fundamental perspective this makes perfect sense – higher US interest rates make the US dollar more attractive from a pure yield basis – it does not guarantee that the greenback will continue to rally.

Adding credence to this view comes this excellent chart from Bank of America-Merrill Lynch’s global rates and currency research team. It tracks the performance of the US dollar leading up to, and following, the start of previous tightening cycles from the Fed.

As it clearly demonstrates, of the previous five tightening cycles started by the Fed, the US dollar has traded lower, not higher, 90 days after the first rate hike was delivered on four occasions. Only in 1988 did the dollar rally, and even then it took two months to kick into gear.

While history alone does not guarantee that the US dollar will weaken on this occasion, it’s clear that markets are now all but certain that a rate hike is imminent, raising the prospect that having “bought the rumour” prior to the hike, markets may well “sell the fact” once the likely rate hike is delivered.

A lowering of the median FOMC fed funds rate path – based off individual FOMC forecasts for where interest rates will be in the future – may actually see longer-term yields fall rather than rise despite the prospect of a rate hike, putting pressure on the dollar as a consequence.

We won’t know whether that will be the case until the rate decision and economic forecasts are released Thursday morning (AEDT) next week.

However, based off history, the fact that a rate hike is deemed as almost certain and likelihood that the Fed will do their utmost to talk down the prospect of an aggressive rate tightening cycle, it’s anything but certain that a stronger US dollar will eventuate.

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