Currency Market Faces Volatility As US Dollar Weakens Ahead of Fed Rate Decision

The Federal Reserve is likely to cut rates this Wednesday, with a high likelihood of a 50-basis point reduction, carrying potential implications for global markets. This decision will significantly impact the U.S. dollar and other economies worldwide. The U.S. dollar has declined recently, breaking through technical support levels and leading to a breakout in EUR/USD. This article will explore the effects of this U.S. interest rate cut and its impact on major currency pairs.

Why U.S. Interest Rate Decisions Matter

The global economy is highly interconnected, and changes in U.S. interest rates have significant ripple effects on other economies. The market expects a 50-basis point rate cut on Wednesday, with a 65% probability. U.S. interest rate cuts can influence the flow of capital, impact investment decisions, and alter the value of currencies. For countries heavily reliant on trade with the U.S. and substantial U.S. dollar-denominated debt, these rate cuts can alleviate financial pressures or heighten economic challenges. Understanding these dynamics is crucial for investors and policymakers to navigate the potential global impacts effectively.

The chart below shows that if the Federal Reserve cuts rates on Wednesday, it will mark the first rate cut during the past four years. The rate hikes in 2022 were initially implemented as part of an effort to combat rising inflation by slowing down economic activity. However, with signs of an economic slowdown and inflation appearing more controlled, the Fed’s decision to cut rates is significant as it suggests a shift towards a more accommodative stance to support growth. This move will lower borrowing costs, encourage spending and investment, and potentially weaken the U.S. dollar, impacting global markets and the broader economic outlook.

The Dollar’s Decline with U.S. Interest Rate Cuts

A cut in U.S. interest rates typically leads to a weaker U.S. dollar as it reduces the yield on dollar-denominated assets. Lower interest rates fuel inflation by making borrowing cheaper, potentially leading to increased spending. This dynamic affects trade balances, as a weaker dollar makes U.S. exports more competitive and imports more expensive. However, the impact on the U.S. dollar’s value depends on how markets perceive the rate cut.

The market is signalling a bearish outlook for the U.S. dollar index, according to the technical breakout observed in the weekly chart below. The chart shows a significant drop in the last quarter of 2022, followed by a consolidation period in 2023. This consolidation forms a triangle pattern. This pattern has recently been broken to the downside, indicating increased bearish pressure. A double-top within this triangle further confirms the downward trend, suggesting that the downward pressure on the dollar remains strong. The interest rate cut and the dovish statement from the Federal Reserve may put additional pressure on the U.S. dollar index, causing it to continue its decline. However, significant volatility during the event could lead to a rebound, which might present a selling opportunity to short the U.S. dollar.

The Impact of U.S. Rate Cuts on Global Markets and Emerging Economies

Emerging markets often hold a significant amount of debt denominated in U.S. dollars. When the Federal Reserve cuts interest rates, it can reduce the cost of servicing this debt for these countries, providing much-needed economic relief. Additionally, a weaker dollar may lead to capital inflows into emerging markets as investors seek higher returns, which can help stabilize local currencies and support economic growth. European equities started the week with uncertainty, showing a lack of direction as increased market volatility is expected. This is similar to the mixed signals from Asian markets, indicating that investors are waiting for the important interest rate decisions from the Federal Reserve. Recent fluctuations in ISM Manufacturing PMI have raised concerns about the sector’s future, making investors cautious about further economic decline.

On the other hand, the persistent decline in USD/JPY raises concerns about the potential unwinding of the Yen carry trade as the pair drops to its lowest level in over a year. This decline suggests significant uncertainty regarding how much more carry trade is left to unwind. A major risk looms over U.S. equities if the Federal Reserve decides on a 50-basis point rate cut, further weakening the dollar and potentially accelerating the unwinding process.

To better understand the impact of the U.S. dollar on major currencies, the chart below illustrates the percentage change in the exchange rates of the EUR, GBP, JPY, CHF, and CAD relative to the U.S. dollar for the 21st century. It shows that the Swiss Franc (CHF) has experienced the most significant appreciation, with an 87.57% increase, indicating a strong performance against the dollar. The Euro (EUR) has also gained 10.27%, while the Canadian Dollar (CAD) has appreciated by 6.39%. In contrast, the British Pound (GBP) and the Japanese Yen (JPY) have depreciated against the dollar, with declines of 19.26% and 28.38%, respectively.

This suggests that the Swiss Franc has been the strongest currency relative to the U.S. dollar in the 21st century, likely due to Switzerland’s economic stability and safe-haven status. Meanwhile, the weakening of the British Pound and Japanese Yen is attributed to economic and monetary policy factors affecting those countries. The fluctuations and divergences in these currency pairs reflect varying economic conditions, central bank policies, and market sentiments over the period shown. Furthermore, it also shows that after 2010, these currencies are trendind in the same direction, indicating that this trend will continue in the coming years.

Currency Market Reactions to Federal Reserve’s Policy: A Technical Overview

EUR/USD: Euro’s Potential Upside Amidst U.S. Dollar Weakness

The EUR/USD pair is one of the most sensitive to U.S. interest rate changes. A rate cut by the Federal Reserve generally leads to a weaker dollar, increasing EUR/USD value. However, the European Central Bank’s (ECB) monetary policy stance will also be crucial. Economic data from the Eurozone and ongoing geopolitical issues may also influence this pair. The monthly chart below provides a long-term view of EUR/USD, indicating that the pair has broken out of a triangle formation and is poised to increase towards the $1.1276-$1.14 region. The price consolidation within the triangle suggests a price compression, which leads to a breakout and indicates bullish pressure.

The discussion above is further validated by the weekly chart, which shows that the pair has already broken out of the triangle pattern and appears strong. After the breakout, EUR/USD corrected lower to test the triangle’s support line and rebounded higher, signaling continued strength in the pair.

GBP/USD: Challenging the Long-Term Resistance

The GBP/USD pair could see an uptick following a U.S. rate cut as the U.S. dollar trades under pressure. However, the British pound’s performance is also heavily influenced by domestic factors, including the Bank of England’s policy. Moreover, the U.K. faces economic headwinds, which may pressure the GBP/USD and limit potential gains. The chart below indicates that the pair trades at a long-term resistance area requiring a breakout. If the pair increases in value and breaks this long-term resistance, the GBP/USD may continue to trade higher.

USD/JPY Continues to Decline from Long-term Pivot

The Bank of Japan’s recent moves to stabilize the currency have put further pressure on the USD/JPY pair in the short term. If U.S. interest rate cuts continue to weaken the pair, USD/JPY may drop more than expected due to the strengthening efforts of the JPY by the Bank of Japan. This is also validated by the technical analysis on the monthly chart below which highlights the pair dropping from long-term resistance with a bearish divergence confirmed by the RSI. The USD/JPY is likely to drop further in the near term.

USD/CHF: Signs of a Long-Term Bearish Trend

Similar to the Yen, the Swiss franc is considered a safe-haven currency. A U.S. rate cut generally results in a weaker USD/CHF as the dollar depreciates against the franc. If global uncertainty rises due to concerns over the U.S. economy, the franc could strengthen further against the dollar. The Swiss National Bank (SNB) is known for its interventions to prevent excessive Swiss franc appreciation. Its response to U.S. rate cuts will determine the pair’s movements.

This is also confirmed by the long-term technical analysis of the USD/CHF, as seen in the quarterly chart below. It shows that the USD/CHF is breaking out from 13 years of consolidation. If the USD/CHF breaks below this consolidation during the heavy volatility of the U.S. dollar interest rate decisions, the pair may experience a sharper decline and continue its long-term downtrend.

USD/CAD: Canadian Dollar’s Range-Bound Movement

U.S. interest rate changes and the oil market influence the USD/CAD pair, as Canada is a major exporter of oil. Since U.S. rate cuts weaken the U.S. dollar against the Canadian dollar, they lead to a lower USD/CAD exchange rate. However, this time is different, as the USD is dropping along with oil prices and U.S. Treasury yields.

The weekly chart for USD/CAD shows price consolidation between $1.3920 and $1.3180, with the pair remaining range-bound for the past two years. Additionally, the market is moving within the broader long-term pivot range of $1.4650 and $1.2060. Since USD and oil prices are declining simultaneously, their opposing impacts on the pair offset each other, causing USD/CAD to remain range-bound within the current range.

Conclusion

In conclusion, the upcoming U.S. interest rate cuts are set to significantly impact major currency pairs, influencing global markets in various ways. A rate cut may weaken the U.S. dollar, benefiting EUR, GBP, and CHF while potentially increasing volatility in pairs such as USD/JPY and USD/CAD. The impact of these cuts extends beyond currency values, affecting global trade balances, capital flows, and economic conditions in emerging markets. Investors and policymakers should closely monitor these developments to navigate the shifting economic landscape effectively, considering how these changes will influence both short-term market movements and long-term economic trends.

If the Federal Reserve decides not to cut rates, the U.S. dollar might experience a short-term rebound due to the unexpected decision, potentially reversing some of its recent losses. This could lead to increased volatility in currency markets, with EUR/USD and GBP/USD potentially facing downward pressure as investors react to the unchanged policy stance.