Bank of America: Will USD strengthen?

22 December,, London – The key question at hand is, Will USD strengthen? The Federal Reserve System (Fed) has taken the first step at normalizing the policy, increasing the Fed Funds rate by 25 basis points (bp) to a range of 25 – 50bp. The Fed has underscored a gradual pace of hikes further out, but left the median dot plot for 2016 unchanged, maintaining approximately 4 interest rate hikes for next year. However, the markets have only priced over 2.5. Hence the market poses, will USD strengthen?

Will USD strengthen

The focus now shifts to the Fed’s subsequent move, Bank of America Merrill Lynch noted. There are still some divided market participants between the “one and done” or “two and through” camps.

Meanwhile, the Fed is trying to communicate otherwise, indicating that they have begun a hiking cycle, albeit historically slow. Yet adding that the first 25bp rate increase is just a minor one and the policy remain accommodative. This way the central bank tried to avoid unnecessary tightening by the more expensive USD. Moreover, Janet Yellen stressed during the FOMC meeting that the Fed will be data dependent: hiking more aggressively if inflation accelerates (suggesting that the labour market is strong enough) and vice-versa if the economy weakens.

“But forecasting the Fed is not just about following the data, it is necessary to understand the Fed’s reaction function,” Bank of America Merrill Lynch advised.

Bank of America: Will USD strengthen?

A key central bank communication tool is the conception of an equilibrium real Fed funds rate, also known as R*.

“While short-run R* is close to zero, the long-run is still believed to be about 1.5% in real terms, suggesting a shallow and slow hiking cycle,” Bank of America Merrill Lynch explained.

Thus confirming the 4 Fed hikes, should the central rise interest rate by 25bp. More importantly, however, will the US inflation increase sufficiently. Until, crude oil prices rebound or any other central bank begins tightening, US inflation data will remain under the market’s spotlight to judge the strength of the USD.

Consider reading: Fed, ECB and EURUSD – CIBC

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