Will The Federal Reserve Give Foreign Exchange Markets What They Want?

by: John M. Mason

- The Federal Reserve is indicating that it will raise its policy rate soon and this possibility is getting a positive response in the foreign exchange markets.

- Since the end of the Fed's quantitative easing III, the Fed has indicated that it would raise rates and the value of the dollar has always strengthened on this possibility.

- If the Fed does raise rates in June/July and raises them once more this year, the value of the dollar could rise to where one euro costs less than $1.10.

Over the past several weeks, the value of the US dollar has risen again. I will focus on just the dollar/euro exchange rate since it seems to capture most of what is happening within the foreign exchange markets.

On May 2, 2016, it took slightly more than $1.15 to purchase one euro.

On Friday, May 27, it took only about $1.11 to buy one euro.

The reason? Over the past four weeks, it seems as if participants in the foreign exchange market are becoming more and more confident that the Federal Reserve is going to raise its short-term policy interest rate.

Supporting this belief, the Fed has seemingly tightened up on bank's reserve positions, something it did in the two months prior to its last policy rate increase in December.

The foreign exchange markets seem to support this possibility in that they have bid up the value of the US dollar in foreign exchange markets.

The foreign exchange markets have generally been supportive of the dollar since the last half of 2014, a time at which the Federal Reserve system indicated that it was going to end the third round of its quantitative easing.

Accompanying this expected Fed action was the fact that the European Central Bank proposed its own effort at quantitative easing in order to keep Europe from deteriorating into a period of deflation.

The combined efforts resulted in a massive rise in the value of the dollar. In April 2014, it took $1.40 to purchase one euro.

At the prospect of the Fed ending quantitative easing and the ECB starting out its own quantitative easing, the value of the dollar rose significantly.

When the Fed ceased its quantitative easing toward the end of October 2014, it also began to provide some "forward guidance" to the markets and the "forward guidance" indicated that officials at the Federal Reserve were thinking about raising its policy rate four times in 2015, moving the rate by a quarter of a point each time.

The first rate increase was expected in the Spring of 2015.

In February 2015, it took only $1.12 to buy one euro.

Since the late spring of 2015, the dollar/euro exchange rate moved into a range of around $1.15 for the euro to around $1.06 per euro.

The value of the dollar rose during times in which it appeared as if the Fed was going to raise its policy rate. The value of the dollar fell during times in which it appeared as if the Fed was not going to make any change.

The volatility in the foreign exchange markets rose as the uncertainty about any Fed rate moves grew.

Finally, in October, it seemed that the Fed what tightening up on commercial banks' excess reserves preparing for a policy rate increase and in December it finally made such a move.

The value of the US dollar strengthened.

But, along with the move came some further "forward guidance" from Fed officials. The "forward guidance" at this time indicated that it was likely for the Fed to raise its policy rate two times in 2016, each move expected to be by twenty-five basis points.

Yet, through early 2016, the Fed did nothing and participants in foreign exchange markets became frustrated. As postponement of any rate increase seemed to grow into the spring months, the value of the dollar fell, as reported above, where by early May it took slightly more than $1.15 to buy one euro.

However, in early May, some Fed officials, including Fed Chair Janet Yellen, began to provide "guidance" that the Fed might act at its June meeting… or soon after in July.

The market rallied.

Market participants grew more confident as the Fed seemed to be reducing excess reserves in the banking system, as I have reported, most recently in the post cited above.

It is my belief that the Fed will raise its policy rate soon, whether in June or July, and that this will be received positively by the markets and the value of the US dollar will remain strong.

It is also my belief that the Fed truly wants to raise its policy rate once again this year and I am in favor of this.

If the Fed does move in June (or July) and then moves once again this year, I believe that the value of the US dollar will become even stronger. Maybe we can look for the price of the euro to fall into the $1.05 to $1.10 range.

Furthermore, I believe that participants in the foreign exchange markets would not be uncomfortable with the dollar achieving parity with the euro so that one euro would cost only $1.00.

But, a lot of other things are going to have to fall into place for this to happen.

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