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What’s behind the Federal Reserve’s decision to pause rates?

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It has been a busy week in the closely watched world of central banks and forex markets. All eyes were on the Federal Reserve, which chose to step away from pulling the trigger on further interest rates hikes. The pause is welcome, particularly given recession fears together with the concern that typically the US central bank is prone to overreact when tightening monetary policy.

“Generally it only stops when it breaks something,” said David Morrison, Senior Market Analyst with Trade Nation. “Many traders believe that ‘that something’ was the collapse of several regional banks earlier this year.”

But while the Fed kept rates unchanged, it also published its forecasts for the direction of monetary policy for the rest of this year and beyond. FOMC members are forecasting two more 25 basis-point rate hikes this year. If so, this would take the terminal rate up to 5.75%, the highest level since January 2001.

“While the market still refuses to believe that the Fed will follow through on this, it has had to do a rapid rethink given that it had been pricing in rate cuts by the end of 2023,” noted Morrison. “That is no longer the case.”


Precious metals sell off after Fed decision

The biggest moves after the Fed decision came in gold and silver which sold off sharply. Traders dumped long positions as the dollar rose on the prospect of further rate hikes, making the greenback more attractive to hold. The question now is whether precious metals can find some support and continue their rally from last autumn, or if further declines are in store.

“The Fed is on pause but at the same time looked at the data and said we think we will need to raise twice more…this does not make much sense to me from a purely monetary policy perspective,” said Neil Wilson, Chief Market Analyst at Finalto. “But because it’s them and because the dots are always a joke I may begin to revise my outlook on how far the Fed might go. And we should note that it’s not just about inflation any more – it seems the Fed probably erred on the side of financial stability in terms of not draining RRP and being able to suck up all the issuance coming over the hill.”

Manufacturing data is also looking a little iffy and harder for USD traders to follow, according to Wilson: “The NY Fed manufacturing survey is, well, erratic,” he explained. “Recently this survey has started to look a tad random. It’s gone from -31.80 pts in May to +6.60 pts in June. It may be seasonal, it may be some quirk of the methodology but the way in which it jumped around lately to me speaks of some underlying problem with the data or a genuine picture of the anomalous recovery (no one has measured recovery after lockdown, it’s not a normal business cycle, etc).”

Could it be all about the labour markets?

The US Initial Jobless Claims number is also worth mentioning here – the result was much higher than expected, coming in at 262,000 vs the expected 245,000. This is the second consecutive elevated number following last week’s number, which was the highest in well over a year.

“If US labour markets are finally starting to soften, this lends some credibility to the Fed’s decision to pause yesterday,” said Ryan Brandham, Head of Global Capital Markets for North America at Validus Risk Management. “The result is a bearish USD and dovish US rates, and a potential reduction in the probability of a hike in July.”

The US dollar bounced back from multi-week lows, as the Fed’s announcement came across as hawkish, telegraphing the intention to reignite its monetary policy tightening later in the year. This mix of pausing but at the same time promising more hikes later in the year, and probably more than one, left some observers wondering what really underpins the Fed’s decision-making. We’re among them.

Ricardo Evangelista, Senior Analyst at ActivTrades, explained further: “It seems as though, having previously set expectations for a pause in June, the central bank was unwilling to respond to a string of strong economic figures with another hike, and tried to compensate by adopting a markedly hawkish stance; a behaviour that contradicts the principle of being data dependent, and may be a sign of division amongst Fed officials. With expectations now set for two more rate hikes in 2023, with the first one likely to come in July, there may be scope for further short-term dollar gains.”

And then there’s the Euro Sterling trade

Britons hoping for a summer holiday boost from the European Central Bank will have to keep waiting. The ECB’s decision to raise its key interest rate to the highest level in over two decades, while also hinting that more rate rises are to come, has pushed the Euro up sharply against the GBP.

But with millions of Britons due to travel to Europe over the coming months, there’s still time for sterling to get back on track. The GBP has risen steadily against the Euro for much of 2023, and even with this week’s setback, sterling is up 3.5% against the EUR since the start of the year. The GBP is faring even better across the Pond, this week sterling hit its highest level against the USD for more than a year, and the GBP is now up 5.6% against the Greenback compared to last June.

“The reason is America’s success at tackling inflation,” said Simon Phillips, Managing Director with No1 Currency. “US inflation is under half what it is here, and as a result the Federal Reserve is taking a breather on interest rate rises.”

By contrast the Bank of England may ramp up UK interest rates again next week in a bid to rein in Britain’s tearaway inflation. This is causing misery for millions of people with mortgages or considering buying a home, but it is also delivering a welcome side-effect for British holidaymakers – for whom the rising pound means more spending power abroad.

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This article does not constitute investment advice.  Do your own research or consult a professional advisor.

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