What could the US Fed’s 50bps rate cut mean for currencies?

By the OFX team | 9 October 2024 | 4 minute read

After years of rate rises to curb inflation, central bank momentum has swung in the opposite direction. And the US is leading the charge.

The US Federal Reserve (Fed) cutting interest rates by 50bps last month has removed the guardrails against inflation and planted a large sign saying “growth this way”.

The new focus is on jobs, according to US Federal Reserve Chairman, Jerome Powell. And how the employment market responds will determine how deeply the Fed will cut¹.

The US dollar’s downward slide prompts a sigh of relief

Two years ago, the US dollar was trading 20% higher than a number of other currencies as the aggressive rate hike cycle sucked foreign capital in chasing higher returns. The dollar index, the US dollar relative to peers, had hit a level not seen since the early 2000s.

As recently as June this year, the US dollar was still trading at a 14% premium, causing a real headache for officials in other countries who wanted to start cutting rates to boost their own economies, but were worried about it devaluing their currencies².

The dollar is involved in nearly 90% of all foreign exchange trades, so a stronger dollar raises inflation, as countries need more of their currency to buy the same amount of dollar-priced goods, like U.S. imports and commodities like oil. Those with dollar-denominated debt also face higher interest costs.

Since the US Federal Reserve’s concerns changed from inflation to jobs, flagging rate cuts, the dollar has fallen 5%, and the is now at a 1% discount to the index.

Central banks accelerate interest rate cuts

All things remaining equal, the US rate cuts should keep that trajectory downward.

Previously, central banks worried about low currencies driving inflation; now, many are concerned that high currencies are hurting export competitiveness.

Take Thailand for example.

Since June, as US rate cut expectations grew, the Thai baht has risen 11% against the dollar, with nearly 5% of that gain in September³.

For the Thai economy, that’s not a good thing. A higher baht makes the country less competitive against its neighbours. The Thai Rice Exporters Association has warned the country’s farmers are losing out to rivals in Vietnam and India, while the Thai Chamber of Commerce worries the higher baht will make Thailand less attractive to tourists⁴.

Business groups urged the Thai central bank to cut interest rates and get the baht down. So far, the central bank governor has not been swayed, but export strength will be on the watch list.

In other regions, US rate cuts have provided room to manoeuvre, allowing them to cut rates without significantly devaluing their currencies.

They need to get their economies moving again, after the impact of higher for longer rates on their economies, as demonstrated by the fall in job vacancies below⁵.

Bloomberg expects 20 of the 23 largest economies – representing 90% of the global economy – to cut rates over the next three months, including more cuts in the US, a half percent rate cut in Europe, Canada, New Zealand, and Indonesia. And a quarter percent cut in the UK, Australia and Korea⁶.

That should keep currencies trading in a relatively tight range with the USD.

China’s new stimulus measures

After a year of without economic growth, The People’s Republic of China has announced stimulus measures⁷.

For the fifth month straight, the manufacturing-sector has been in contraction, its property sector has seen a wave of bankruptcies, the services sector has turned down, and retail sales are slowing.

Last week, the People’s Bank of China (PBOC) cut its benchmark interest rate and reduced the reserve requirements for banks to boost lending. It lowered the interest on existing mortgages and reduced down payments for second homes, while injecting cash into the stock market.

Those efforts saw the stock market shoot up 25% in a week⁸.

The Chinese yuan jumped to its highest level against the US dollar in 16 months as investors cheered the package, in the short term at least⁹. It has since retraced, however, as markets worry whether the policy action is could be a sign of upcoming economic reform.

Interest rate cuts should push a currency lower, as investors seek a higher yield. But China is unusual in that foreign investors are not significant owners of Chinese government bonds¹⁰, meaning its bond yields are less influential on currency strength.

This week’s rise in the yuan may have more to do with the hopes of stock market investors. Past stock market rallies driven by government stimulus have led to trough-to-peak gains of about 50% to 100%¹¹ and Goldman Sachs has said that hedge funds have made record purchases of Chinese shares¹².

The Aussie dollar advances on two-pronged momentum

The one currency with clear upward momentum is the AUD.

It was already on the incline against the US dollar over interest rate divergence. While other countries have been cutting rates, the Reserve Bank of Australia (RBA) has ruled out rate cuts until at least next year, saying the risk of inflation is still too high¹³.

The AUD hit a 19-month high of US$0.6908 against the greenback, helped by another leg up on all that China stimulus¹⁴.

Australia is very tightly correlated to China, whose terms of trade is massively geared toward China’s construction industry, and mining stocks on the Australian stock exchange have soared.

The Aussie dollar has more life in it, according to currency watchers, with ANZ Bank and Bank of America expecting the AUD to climb to US$0.71-US$0.72 by the end of next year¹⁵.

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