Discounting the Fed Hikes

Fed Chairman Jerome Powell commented in a speech yesterday that the central bank is “a long way” from getting rates to neutral, and that the Fed no longer needs the policies that were put in place to pull the economy out of the financial crisis. Powell’s statements were interpreted by the markets as a sign that more interest rate hikes are coming.

Remember that one of the tenets of fundamental analysis is that prices react to new information and that traders tend to discount their expectations about the future into the price. Also note that interest rate hikes tend to increase the value of the currency given that it is now more profitable to invest in it due to the carry trade. In anticipation of an interest rate hike, traders could start purchasing USD given that they expect it to rise. This would result in a preliminary increase in the exchange rate, in anticipation of the rate hike.

This can be viewed in the USD behaviour following Powell’s comments. As the four currency pairs in the above picture show, markets have discounted this information and the US Dollar has increased compared to the Euro, the Yen, the Loonie and the Ruble, and other currencies not included here. An interesting question is whether this appreciation will be persistent or not. The answer is that if we could somehow freeze all data and all speeches from happening and no other pieces of information entered the price, then the level observed would most likely persist. Naturally, freezing news announcements is not an option, hence there is no way to tell whether the price will remain at the same levels, given that new information has not yet arrived. Still, what matters is that traders need to be aware that markets tend to discount information and hence be ready to either exploit it or protect themselves against it.

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Dr Nektarios Michail

Market Analyst


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