What Did Fed Do to Make Dollar Pop?

By Kathy Lien, Managing Director of FX Strategy for BK Asset Management

With the Federal Reserve holding its first monetary policy meeting of the year, it would be easy to attribute today’s dollar rally to the central bank’s comments.

However, nothing in Fed Chairman Powell’s Q&A session warranted today’s spike in the dollar and losses in equities. A rally like the one we saw today in the greenback would normally be fueled by hawkish commentary.

Instead, the changes to the FOMC statement were slightly more dovish – the central bank acknowledged the moderation in activity and employment in areas hit the hardest by the pandemic and predicted modest inflation this year. This cautious outlook explains why Powell thinks its “too early to focus on tapering dates.” He said they are still a long way from meeting inflation and employment goals so when its time to “gradually” taper, they’ll let us know well in advance. By avoiding any specific timeframe on taper, today’s comments should have driven the dollar lower and not higher.

So why did the greenback pop? The answer is stocks.

The Dow Jones Industrial Average dropped more than 2% to a 3 month low on concerns that speculators could be met by regulators. It was FOMC day but no one can stop talking about Gamestop and the short squeezes driven by Reddit and WallStreetBets. Some investors are worried that massive losses by hedge funds could force liquidation of other investments.

In fact, unwinding risky bets is one of the main reasons why the dollar was driven higher today. If tomorrow’s US fourth quarter GDP report misses expectations, the slide could accelerate quickly. In times like this it is important to remember that corrections are always faster and more aggressive than rallies. With retail sales falling every month in Q4, the risk is to the downside for tomorrow’s report. USD/JPY is vulnerable to a correction but a dollar rally will be felt the most against high beta currencies. EUR/USD, AUD/USD and NZD/USD are at the greatest risk for losses.

Stronger than expected Australian inflation data and Chinese industrial profits failed to help AUD and NZD, the day’s worst performers. While the fundamentals for both countries are strong and virus cases are low, these currencies enjoyed strong gains in 2020 and were the most vulnerable to a correction. NZD’s losses could accelerate if tonight’s trade data surprises to the downside.

German inflation data is also due for release tomorrow. Although price pressures are expected to increase, inflation is so low that any uptick will be ignored. EUR/USD slipped to 1.21 before FOMC but between the market’s appetite for US dollars and some concerns about the currency’s appreciation from ECB officials, the next stop for the currency could be 1.20.