3 Reasons Why Dollar Soared on Fed’s New Inflation Strategy

The Federal Reserve has a new inflation strategy. Instead of focusing on curbing price pressures, they will now allow inflation and employment to overshoot their targets in order to attain long term price stability. This new approach follows nearly a decade of inflation falling short of their 2% target. Even before COVID-19, the Fed had been thinking about changing its focus. This decision was made after more than a year of analysis and ushers in a new phase for the central bank.

The coronavirus pandemic gave the Fed a stronger reason to shift gears as the slowdown in the economy scraps any potential inflation recovery. With today’s announcement, the Fed is telling us zero interest rates are here to stay and they will allow the economy to run hotter than usual before they tighten monetary policy. The prospect of years of low interest is wildly positive for stocks and explains why S&P 500 hit a fresh record high. However accommodative policy guidance should be negative for the dollar and yet the greenback rose sharply versus the euro and Japanese Yen.

We’ve identified three reasons for the dollar’s post Jackson Hole rally:

1. Fed’s announcement was priced in – Although the dollar shot lower when Powell first made his announcement, it u-turned shortly thereafter. One of the primary arguments for this reversal was that it was widely expected. As we wrote in yesterday’s note investors had been looking for the central bank to shift to an average inflation target which was language used by Powell today. When it became clear that there were no surprises in his speech, investors returned to taking profits on high beta currencies.

2. Dollar rallies as investors return to US assets – The promise of cheap money and ample liquidity are also drawing investors to US assets and in turn the US dollar. Its hard not to be attracted by the record breaking moves in US stocks. The Fed’s new policy will help to rev the economy and allow it run hot longer. The dollar also has a strong correlation with Treasury yields and the nearly 8% rise in 10 year rates contributed to the rally.

3. Tinge of optimism from Powell – We had been looking for cautious comments from Fed Chairman Powell and instead his comments were slightly more upbeat. The Fed Chair described the economy as healthy, apart from virus hit areas. US data was also better with Q2 GDP revised slightly higher, pending home sales beating expectations and jobless claims resuming its decline. Personal income and personal spending numbers are scheduled for release tomorrow

The Japanese Yen was hit the hardest by the dollar’s rise. Given USD/JPY’s correlation with 10 year rates, this is no surprise. Prime Minister Abe is also scheduled to hold a press conference tomorrow and many wonder if he’ll resign over health concerns. Euro underperformed as virus cases in France and Spain surge at alarming rates. The Canadian dollar was the most resilient thanks to stronger current account numbers and the prospect of a better monthly GDP tomorrow. The Australian and New Zealand recovered most of their post Powell losses thanks to the risk rally. The renewed focus on Europe makes Asian currencies more attractive. Sterling on the other hand lagged behind as UK virus cases rise to their highest level since June.