usd flounders under a dovish fed 1330962015

At its highly anticipated September meeting, the Federal Reserve chose to remain on the sidelines in light of a deteriorating global economy and soft inflation domestically, overshadowing evidence of broad US economic recovery. The bank left the target range for the federal funds rate at 0-0.25% by a vote of 9-1. The lone dissenter, Lacker, voted to raise the target rate by 25 basis points, which is in complete contrast to one unknown Fed member who placed a dot below the zero line, hinting at the unlikely possibility of negative interest rates (see the FOMC Recap by my colleague Matthew Weller).

Overall, most policy makers still expect the Fed to raises interest rates by 25 basis points this year, although that number has shrunk. Three policy makers now expect the Fed to remain on hold until next year. The bank warned that recent developments in global markets are holding back the US economy and weighing on inflation.

It has been a tumultuous time for the global economy, which has been shaken by extremely volatile markets attempting to reassess the longevity and stability of key global economic powerhouses, namely China. The world’s second largest economy has been struggling due to a lack of global demand and domestic economic activity, as well as a massive sell-off in its equity markets. Not only has this cast doubt over the health of a key global economy, it has also reinvigorated US dollar bulls. While the direct exposure of the US economy to its exporters isn’t overly significant, the interconnected nature of the economy is passing on the deflationary effects of a stronger US dollar.

The wash-up

The US dollar sunk on the back of today’s dovish policy meeting and accompanying press conference from Chair Yellen as traders pushed out expectations for policy tightening, with the market now split over whether the bank will raise at all this year. However, the reaction was less emphatic in equity markets which were only momentarily bolstered by the dovish tone of the Fed. Risk-off sentiment is still poising key markets and assets, like the aussie and kiwi which have given back most of their earlier gains against the US dollar.

USDJPY: knee-jerk reaction?

Nonetheless, the safe haven yen is still well-above its pre-FOMC position, with USDJPY just re-emerging above 120.00 at the time of writing. However, the yen is unlikely to make the most of the gains in the near-term given the increased prospect of further easing from the BoJ. Even though the expected policy prospects of the US and Japan have tightened recently, with the Fed delayed raising interest rates and the BoJ refusing to bow to market pressure for further easing, the long-term divergence of yields between the two nations should keep USDJPY bears at bay.