A Fed Rate Hike does not mean US Dollar Gains
by, David Frank, Economist

The EUR/USD Forex market has been volatile over the last several trading days. Last week, on Monday, the euro hit a low of 1.0505 in Asian trade before hitting a high of 1.0872 in New York trading hours. Then the European Central Bank (ECB) surprised with even more liquidity and the euro lost even more ground, closing the week at 1.0554.

To be fair to the ECB, it was highly unlikely that ECB President Mario Draghi or his merry band of policy makers were going to be able to meet everyone’s needs or wants. However, the central bank came pretty close. The markets wanted an additional six months of quantitative easing or €480 billion of asset purchases at €80 billion a month. They got €540 billion more with a nine month extension at €60 billion per month.

The ECB was careful to point out that this reduced pace of bond purchases does mean they are “tapering.” Should the outlook become less favorable or if financial conditions become inconsistent with progress as far as meeting their inflation target, the ECB could adjust this program once again for size and duration.

ECB Changes Euro Bond Buying Requirements

Also the ECB announced they would start buying assets with yields below the deposit threshold of -0.4 percent. They would also buy bonds with a yield to maturity (YTM) as low as one year. Previous they would only go as low as a two year YTM. This is an important adjustment to their implementation of QE. This will also take buying pressure off the long-end of the yield curve. Investors will no longer need to front-run actions by the ECB. This will also allow the central bank to drive short-term rates even lower. In the context of a rising yield environment, a steeper core of sovereign yield curves will support Forex markets like the EUR/JPY but hurt the EUR/USD and EUR/GBP.

While the recent ECB decisions will shape the common currency of the next several weeks, Forex traders need to watch developments with two other lines of news. First is Italy, a new prime minister will be appointed soon as their foreign minister, Paolo Gentiloni, was given a mandate to form a new government. Parliamentary approval should be granted on Wednesday.

Another piece of news is Wednesday’s Federal Open Markets Committee (FOMC) monetary policy decision and announcement. This is the Federal Reserve’s last meeting of the year and the hawkish views are pointing to a Fed funds rate hike of at least 25 basis points. This could prop up the US Dollar rally even more.

EUR/USD Chart

The EUR/USD Forex market, could already be predisposed for lower prices but the FOMC monetary policy meeting could only bring about this result if they steepen the rate hike curve into the New Year. This is a difficult scenario to grasp as the Fed called for only two rate hikes in 2017 and markets are pricing in two hikes for June and December.

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