The U.S. dollar is weakening ahead of Fed rate cut. This will determine what happens next.

By Vivien Lou Chen

The need for a larger cut from the Fed would point 'toward growth concerns and economic trouble ahead,' says analyst Joe Tuckey

A previous version of this article incorrectly stated that the Federal Reserve's 50-basis-point interest-rate cut on Wednesday would be its largest in 16 years. This has been corrected to reflect that the Fed moved to cut rates twice by 50 basis points and 100 basis points in March 2020.

The U.S. dollar has been sliding in the run-up to a widely expected interest-rate cut from the Federal Reserve on Wednesday and, depending on the size of the Fed's move, it could end up weakening further - or it may be a buying opportunity.

The dollar, as reflected by the ICE U.S. Dollar Index DXY, was trading near its lowest levels of the year on Monday, at around 100.77 - down from as high as 106.26 in April. When measured against the yen, the greenback depreciated to a more than one-year low on Monday.

Contributing to the decline in the greenback is a greater-than-50% market-implied likelihood that the Federal Reserve will deliver its biggest rate cut in more than four years on Wednesday. Expectations for a 50-basis-point cut jumped to 63% on Monday from 50% on Friday, after Wall Street Journal commentator Greg Ip made the case for a bigger cut and Bill Dudley, the former head of the New York Fed, indicated he expects the Fed to deliver just that. Meanwhile, the likelihood of a 25-basis-point reduction fell to 37%, down from 50% at the end of last week, according to the CME FedWatch Tool.

A larger Fed rate cut on Wednesday "may well drive the dollar to new lows," while a smaller 25-basis-point reduction "would likely initiate far less currency volatility," said Joe Tuckey, head of foreign-exchange analysis for Argentex, a London-based provider of currency-risk management and payment solutions. One reason for his view is that, "in essence, the need for a larger cut points toward growth concerns and economic trouble ahead," Tuckey wrote in an email on Monday.

The dollar tracks U.S. growth prospects, the direction of interest rates set by the Fed, and where rates are headed relative to the rest of the world. The yen has been strengthening against the dollar because the Bank of Japan is widely expected to raise rates again by year-end, after having already lifted borrowing costs in July and ending its negative-rate policy in March. Officials at the Bank of Japan are scheduled to make their next policy announcement on Friday, two days after the Fed's decision.

Uncertainty about the size of the Fed's first rate cut is growing - an unusual development, considering that officials have worked hard to communicate in a clear way and that the central bank's two-day meeting begins on Tuesday. The Fed has held rates at a 23-year high of 5.25% to 5.5% for more than a year.

Traders are focused on two lines of thinking at the moment. One is that a 50-basis-point cut, which would be the first since the onset of the 2020 Covid-19 pandemic, is needed to keep the U.S. out of a recession, to prevent borrowing costs from turning overly restrictive as inflation eases, or both. The other is that big rate cuts are reserved for emergency purposes only and, with the economy still holding up, a 25-basis-point cut is more likely and would enable the Fed to act in a more gradual way.

"The Fed looks ready to kick-start rate cuts, with the major question around 25 or 50" basis points, said TD Securities strategists including Mark McCormick. Referring to the Fed's interest-rate forecasts, the TD team said that "while the dots and tone of the message should dictate the trading around the event, we firmly believe that the data will matter more than the rhetoric in the weeks and months ahead." The strategists added that the dollar is "closely tracking" U.S. growth proxies, for example.

At TD, discussions with clients "generally center around whether the [U.S. dollar] has further room to weaken as the Fed starts to cut, or whether this is a buying opportunity as the narrative pivots. We're in the latter camp for the next few months," the strategists wrote in a note on Monday. "The Fed should start at 25, erring on the side of caution. ... Plus, USD positioning now is clean on our models, and we think we're at max central bank divergence," or levels at which central banks around the world are likely to diverge on rates.

-Vivien Lou Chen

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09-18-24 1734ET

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