Fed stays put on rates, sending DXY dollar index lower 

On Thursday, the U.S. dollar index saw a broad decline, with risk-oriented Asia-Pacific currencies leading the way as investors became increasingly convinced of a potential peak in U.S. interest rates after the Federal Reserve's decision to leave them unchanged in the 5.25% to 5.50% range on the previous day. 

Although Fed Chair Jerome Powell left the door open for another hike, he acknowledged that the risks of doing too much or too little were now balanced, given the funds rate's current 22-year high of 5.5%. 

Interpreting this as a signal to maintain their expectations, markets continued to assign a 20% probability to a rate increase in December, according to data from CME’s FedWatch tool. Following the decision on Wednesday, ten-year Treasury yields fell 23 basis points from their highs, equities rallied, and risk-sensitive currencies rebounded. 

The dollar index, which gauges the strength of the U.S. currency against six major counterparts, was last down 0.88% on the day at 105.93, according to MarketWatch data. 

The euro gained 0.91% to $1.066, the British pound rose 0.58% to $1.22, and the Japanese yen continued to recover from its one-year low, reaching 149.89 per dollar. 

Interest rate forecasts: Analysts read Fed’s move as dovish 

Kristoffer Lomholt, head of FX research at Danske Bank, told Reuters correspondent Samuel Indyk on Thursday that markets had likely expected a more hawkish tone from Powell: 

"Powell had the opportunity to raise a bit of concern with the latest rise in short-term inflation expectations but he chose not to do that. There was a possibility of sending a much more hawkish signal but he chose not to and I think that's what markets are reacting to." 

In his morning notes on Thursday, Markets.com Chief Market Analyst Neil Wilson broadly agreed with Lomholt in that markets read Powell’s speech as dovish: 

“Powell was dovish – at least that’s how the market read it. The Fed left rates on hold with a little-changed statement aside from adding that there were tighter ‘financial’ as well as ‘credit’ conditions that might ‘weigh on economic activity’”. 

In a longer-term interest rate outlook, Wilson referred to DoubleLine Capital founder Jeff Gundlach’s recent comments of interest expenses taking a toll on the U.S. economy, as well as investor Stanley Druckenmiller, who recently said he took “massive leveraged positions” on safer assets after getting “really nervous” about the economy. Wilson also commented that the Fed “isn’t anywhere near as close to cutting interest rates” as markets expect: 

“Doubleline’s Jeff Gundlach expects economy to roll over and sees Fed cutting by 200bps. This is the great fight – between those who think the Fed will revert to big cuts when the economy slides, and those who think it will stick the course on higher for longer. Maybe the bond rally has begun? I don’t buy it. I think we get [a weaker] economy and sticky inflation and the Fed won’t be slashing rates. Gundlach’s comments probably reflect a total lack of confidence in the Fed and Treasury – much like Druckenmiller... a general sense that things are not right. 

The Fed probably won’t hike again, so the question is when to cut? The market will be front-running this now, which could see some short-term gains for stocks, but I don’t think the Fed is anywhere as close to cutting as the market thinks. If the Fed is going to have to accept higher inflation, as I have, you could also argue that it’s got to be more willing to cut sooner.” 

USD forecast: Scotiabank’s Osborne sees 1% risk of DXY dropping to low 105 area 

Shaun Osborne, Chief Currency Strategist at Toronto-based Scotiabank, wrote that USD losses may extend in the near term as markets detect signs of the Federal Reserve relenting on rates. However, he saw a low risk of the DXY index dropping to the low 105 area: 

“Investors may be looking for an excuse to cover massive Treasury shorts, given bullish comments from a range of high-profile investors recently.  […] 

Fed Chairman Jerome Powell's dovishness, softer US Manufacturing ISM, with weak details, and a further sharp drop in the Atlanta Fed’s GDPNow tracking, suggesting the US economy is slowing sharply in Q4, might have been enough to get more investors on board for a bond and risk rebound. […] 

Another rejection of 107+ levels for the DXY is starting to firm up the longer-term technical ceiling on the index now and points to near-term risks of a 1%-ish drop to the low 105 area from current levels at least.” 

At the time of writing, the DXY index traded at 105.93, down 0.88% on the day, as per MarketWatch data. Given the recent retreat, the dollar index was on track to post close to a 0.65% decline for the week.