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How Does the Dollar Trade Before and After Fed Tightening?

Last updated 12/8/2009 7:53 AM ET (GMT -5) 4 Comments

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Kathy Lien

Director of Currency Research, GFT

The latest comments from Federal Reserve Chairman Ben Bernanke suggests that he is not convinced that the improvement in the labor market will last, but the price action in the currency market indicates that traders are still repositioning for an earlier unwind of the Fed's ultra easy monetary policy measures. As the Federal Reserve inches closer to raising interest rates, we we thought it would be interesting to examine how the dollar trades before and after Fed tightening. In order to gather this data, we looked at the Fed’s tightening cycle only after a prolonged period of easing or steady monetary policy. 

We examined 8 periods of tightening over the past 3 decades and compared how the EUR/USD and USD/JPY traded before and after the Federal Reserve began to raise interest rates. To help understand these tables, in 2004 for example, 3 months before the Fed began to tighten, the EUR/USD was trading 2 percent lower. In other words, it appreciated 2 percent ahead of the rate hike. Three months after the Fed actually tightened, the EUR/USD was trading 1 percent higher which means that after the rate hike, the euro actually strengthened against the dollar. 

Based upon our analysis, the only discernable trend is that contrary to the popular belief that a rate hike in the U.S. should be positive for the dollar, the greenback tends to weaken against the Japanese Yen after the Federal Reserve begins to raise interest rates. Aside from 2003, we see a very consistent pattern of dollar weakness once the tightening cycle begins. The primary explanation is that the Fed would only raise interest rates if growth is strong and stronger growth in the U.S. tends to benefit trading patterns like Japan who see their exports expand exponentially. For the EUR/USD, the only trend that we can identify is the bias for dollar strength, euro weakness in the 3 months after the Fed begins to raise interest rates - the EUR/USD either remains virtually unchanged or weakens. We also see a mild bias for dollar strength in the 3 months going into the rate decision. It remains to be seen whether this pattern will be repeated in this tightening cycle, but it certainly helps to know how the U.S. dollar has performed in the past. 

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Comments (4)

m.hollingshaw

December 08, 2009 at 04:17 PM ET

If the labour market does not continue to improve as he alludes to, do you think that would reignite dollar carry or has the NFP sort of indicated that growth is on its way and changed the market completely?

tjbab

December 08, 2009 at 04:36 PM ET

T.Bormuth
I think the recent employment data was up because of temp jobs for the holidays.What will happen after Jan 1. My thought is unemployment numbers will rise

archer357

December 08, 2009 at 10:11 PM ET

thats great insight tjbab. i think your right. time will tell

rsm

December 09, 2009 at 02:47 PM ET

employment data was "ip" because 291,000 people "left the workforce". In spite of the population growing, fewer people are somehow seeking employment.
Also, the jump in tax withholdings from October to November in 2008 was $1.057 billion. The jump in 2009 was $0.780 billion.

Adjustments will be made at point in the future.

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About The Author

Kathy Lien began her FX trading career 10 years ago at J.P. Morgan Chase. After graduating New York University’s Leonard Stern School of Business at the age of 18, Kathy joined the bank's interbank FX trading desk and eventually moved to the cross markets proprietary trading desk. In the interbank market, her ability to create solid fundamental and technical analysis from the myriad of information on the market helped her trade forex spot and options. Her experience eventually led her to be chief strategist at Daily FX where she worked until she joined GFT in 2008.

With her knowledge of forex, as well as her experience trading other products, such as interest rate derivates, bonds, equities, and futures, Lien has built a reputation as an international currency analyst. She is frequently quoted on CNBC, Bloomberg, Fox Business and Reuters. Lien has also written for publications like Active Trader, Futures, and SFO magazine. She is the author of the newly updated Day Trading the Currency Market: Technical and Fundamental Strategies to Profit from Market Moves, and the co-author of Millionaire Traders: How Everyday People Are Beating Wall Street at Its Own Game with Boris Schlossberg.

To buy Kathy’s newly updated Day Trading and Swing Trading the Currency Market: Technical and Fundamental Strategies to Profit from Market Moves, click here.