The Fed lowered interest rates on Tuesday, yet the dollar didn't go down. Understandably, many currency investors are scratching their heads in wonder.
In the longer term, the dollar still has huge problems. The Fed doesn't support its own currency and continues to print money at an alarming pace. As it does things like this, it devalues the currency longer term, no matter what the U.S. Treasury says about an official "strong dollar" policy.
Unless this changes, the long term fate of the greenback won't change either.
Yet the short-term reaction on the rate cut is a quick lesson in how traders react to events, and they are important to bear in mind. Let me explain.
The Fed cut rates by 75 basis points, but then it went on to explain why: Consumer spending has slowed, labor markets have softened, and financial markets remain under considerable stress, reported the Fed.
The deepening credit and housing contraction are weighing on economic growth and probably will continue to do so for the next few quarters.
So, up until this point, a trader might think, "Okay, a bad economy coupled with a lower but uncompelling rate change should drive the dollar lower."
However, there are several factors at work.
For one, Fed chief Ben Bernanke said that "inflation has been elevated and some indicators of inflation expectations have risen." Currencies react positively to rising inflation because eventually you have to tackle this by erasing those rate cuts — even hiking rates.
Traders took advantage of that thought on Tuesday and drove the dollar higher. Whether the rally is sustainable is doubtful, but nonetheless it happened.
Remember, too, that commodities like oil are priced in dollars. If the economy is slowing and is going to continue to do so, as the Fed estimates, then there may be less demand for oil.
If so, then the price of oil should trade downward. This is what it did upon the news.
Oil and other commodities working their way down pushes up the dollar against them. So the rate cut also brought down foreign currencies against the dollar like the euro, pound and yen. These pullbacks may be short-lived, but that's why they happened.
So just as traders had gotten comfortable with their "one way bet" in the EUR/USD (the exchange rate between the euro and the U.S. dollar), the trade changed. The euro had enjoyed a huge run — some of which was based off of superior European fundamentals to that of the buck but some of it was due to it being the "anti-dollar" or dollar alternative currency.
EUR/USD has gone into the stratosphere lately, approaching the 1.60 level. Just one euro was buying almost $1.60. Wow!
So the market took a short term overbought EUR/USD and grossly oversold USD/JPY (dollar vs. the Japanese yen).
Then the market used that as an excuse to bring the dollar back towards its mean as it "played" upon the inflationary news and the near term fall in gold, oil, and other commodities.
Even in bull markets such as commodities are experiencing right now, they all have healthy pullbacks within the uptrend. Gold and oil and other commodities are about to go through one of those.
As they do, it will help the dollar in the short term, especially against the euro.
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