The relationship between US interest rate cuts and the dollar's value is not as straightforward as it may seem. While many assume that rate cuts automatically weaken the dollar, a new analysis from Société Générale (SocGen) reveals a more nuanced picture.
SocGen strategists, Kit Juckes and Olivier Korber, have examined the historical correlation between the ICE US Dollar Index (DXY) and the federal funds rate over the past 40 years. Their findings suggest that deep rate-cutting cycles have consistently led to a decline in the dollar, but shallow rate-cutting cycles have had a less significant impact.
Their analysis highlights key instances:
1985: The dollar fell significantly, but only after four months of the first rate cut.
1989: The dollar started falling shortly after the first rate cut, but rallied between the first and third cuts in 1995-96.
1998: The dollar fell even before the Fed cut rates, influenced by the Long-Term Capital Management (LTCM) collapse.
2000: The dollar was declining when the Fed initiated easing.
2001: The dollar bounced before falling sharply in 2002-04 as interest rates continued to drop.
2004: The dollar mostly fell as rates rose, and although it recovered in 2005, it was already on a downward trend long before the Fed's easing in 2007.
2019: The only rate-cutting cycle since then began in July 2019, initially leading to a dollar decline. However, the dollar's fall continued even after the COVID-19 pandemic hit, further highlighting the impact of unprecedented Fed easing in 2020.
For investors and traders, the takeaway is clear: a prolonged period of Fed easing is likely to weaken the dollar. However, a brief, shallow rate-cutting cycle, as witnessed in 1996 and 2019, may not trigger a substantial dollar decline. This is because investors may be attracted to US assets, offsetting the potential impact of rate cuts.
Looking at the present situation, SocGen notes that the current dollar peak is the highest in real terms since 1984-85, surpassing even the 2002 high. These periods were both marked by delayed but substantial dollar falls, accompanied by deep Fed rate-cutting cycles.
"The current dollar's level, and the size of the positioning that got it there, argues for a big move," SocGen wrote. However, "Expectations that the Fed can ease, avoid a recession and see U.S. economic exceptionalism persist argue for caution."
In conclusion, while the relationship between rate cuts and the dollar's value is complex, a deep rate-cutting cycle is a strong indicator of a weaker dollar. This insight is crucial for investors and traders navigating the current market landscape.