US Fed Prompts Small Pound to Dollar Rate Recovery but Strength Forecast to be Limited

The British pound to dollar exchange rate (GBPUSD) recovered strongly in the wake of the US Federal Reserve’s March policy meeting, the gains could however be brief.

• GBP/USD had been under notable pressure until Federal Reserve scales back ambitions on interest rate policy
• Suggestions being made dollar weakness will be temporary

Those with imminent dollar payments were thrown a lifeline overnight after the US central bank fostered a sudden bout of dollar weakness.

The dollar's declines were registered across the board but already we are hearing that this weakness may only be temporary on the account of markets possibly overreacting.

At the time of writing GBP/USD is at 1.4228 - still far below Monday's open at 1.4378.

The Federal Reserve's Open Markets Committee (FOMC) turned out more dovish than expected - i.e more cautious in tone and less willing to raise interest rates agressively in 2016; a condition required to support USD gains.

A statement released by the Fed following their meeting acknowledged some economic improvements seen since January while remaining cautious with regards to the intended pace of interest rate lifting. 

Again the Fed has taken into account global financial and macro developments in its decision-making, a relatively recent development by Fed's historical standards.

In line with expectations, the forecasts delivered regarding the economy were little changed but conveyed lower growth and inflation expectations for 2016. 

The infamous 'dot plots' were revised downwards suggesting a less aggressive tightening cycle.

A poll of economic analysts ahead of the event showed expections for a revision to 75bp in hikes during the year to be made.

But the range of 0.5-0.9% as the estimated year-end Fed funds rate implies we could expect between one and two additional hikes.

"Investors punished the dollar because Janet Yellen failed to emphasize that 2 more rate hikes are expected this year and instead spent the large part of her testimony talking about the troubles in the U.S. and global economy," says Kathy Lien at BK Asset Management.

The whole estimate for the Fed funds rate was revised downwards (i.e. the majority of FOMC members now expects a terminal rate in the range of 3.00%-3.25% vs. 3.5%-4.0% in December).

"The press conference was even more dovish, with heightened concerns over the global macroeconomic outlook, the inflation forecast biased to the downside and emphasis on a low long-term rate with a gradual pace of normalisation," says Ociel Hernández Zamudio at BBVA Bank.

Why US Dollar Losses Could be Limited

We have seen the USD fall, but what of the outlook?

BK Asset Management’s Lien says there are two reasons to believe weakness in the Greenback will likely be limited:

1) The Fed is still looking for 2 more rate hikes this year, which is 2 more than any other major central bank.  Janet Yellen talked a lot about how the dot plot reflects individual views that and noted the considerable uncertainty in each participant's forecast.  

2) Yellen said the forecasts aren't a preset plan, commitment or promise of action.  By downplaying the significance of the dot plot, she implies the potential for more or less action from the Fed.

“While this could be interpreted to mean that the Fed could forgo raising rates completely in 2016, her expectation that U.S. growth will run above potential, her view that every meeting including April is live for tightening and their decision to provide no guidance on the balance of risks suggests that there's still support for tightening in 2016,” says Lien.

Indeed, Fed President George voted for a rate rise this month.

The pound is already down on the day, and while there is the prospect of more gains, or consolidation, ultimately the longer-term trend of decline will likely re-establish. 

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