US Dollar Might Drop Up to 20% After Fed Hike

As the US Federal Reserve prepares for a first time in a decade increase in borrowing costs, currency market participants are buying into the dollar, seeking to sell at its highest value, which is, as history shows, just before the actual tightening move. 

 After a year of gains, propelled by the expectations of the US Fed’s base interest rate increase and the weakness in most of the world’s currencies, the greenback is at about its highest value before the Fed finally moves to raise borrowing costs in September.

The period after any move to tighten monetary policy is characterized by sell-offs in assets of the given nation, meaning the long-overdue Fed hike is likely to cause a tumble in the US dollar’s value. That said, now might be just the right time to sell the greenback as a risk-hedging precautionary measure.

Although the apocalyptic forecasts and expectations of an imminent collapse of the US currency are all but far-fetched, it is fair to say that a rise in the base interest rate, if it comes in September, will trigger some market correction, including that in US dollar trading.

As US borrowing costs rise, a decreased effective demand for US currency-denominated monetary liquidity is an essential consequence.

Amidst a lower demand for the dollar, its value will inevitably lose some ground. What is important here is to understand the right time to sell before being affected by the correction of the dollar’s value, and also the scope of the potential greenback’s retreat – though hardly significant, but biting.

The historic Fed interest hikes show that the US dollar rallied some 9% on the average six to nine months prior to the actual policy move. After the hike, the dollar would retreat up to 6%, or 2/3 previous gains, during the next six months. That happened each time during the early tightening cycles in 1993-94, 1999, and 2004.  Investors bought into the dollar on the tightening anticipation, and sold upon the actual rate hike.

The current situation is slightly different, though. The greenback rallied over the past 12 months, adding more than 30% during the period due to the combination of both domestic and overseas factors. Simple calculations might suggest a 20% dollar slump straight after the Fed hike, but there is more to the situation.

The Bloomberg Dollar Spot Index, tracking the greenback against its 10 major peers, only rose 6.8% this year, suggesting most of the dollar’s strength is attributed to the weakness elsewhere instead of the dollar’s sudden strength.

Previously, the yearly scale of the Fed’s rate increase totaled 2.25%, while this time around the regulator is more dovish, promising only an increase of 1.625% in US borrowing costs by late 2016 (more than a year will have passed by then). The recent devaluation in mainland China’s renminbi may even prevent the Fed from the anticipated September increase.

All that means that the dollar’s post-hike retreat might turn out to be more significant than the previous average of 6%. The dollar actually dropped 6.9% in 1994, but just 1% in 1999, falling to a stunning 9.3% in 2004. However, even in the worst scenario, the greenback will not slump more than 20% this time around.

At this point, market participants are predicting a 46% probability of a September hike, the anticipated tightening scope is at 0.375%. The Fed announcement will be the trigger to the dollar’s sell-off.