Forex.com | Feb 09, 2024 02:15AM ET
The central bank of the United States, the Federal Reserve, dates back more than 110 years to 1913.
The Fed was initially created to promote economic stability and break the cycle of frequent, recurring financial crises and widespread bank failures (1907, 1901, 1896, 1893, 1890, 1884, 1873…). At its core, the Federal Reserve system was designed to provide a more elastic currency, enhance financial stability, and mitigate the impact of banking panics.
Over its century+ history, the Fed has evolved dramatically into a complex institution with a number of key responsibilities, highlighted by its dual mandate to pursue “maximum employment and stable prices.” As many traders know, its primary tool for achieving those goals is monetary policy, or adjusting interest rates and changing the money supply.
Put simply, when the economy is struggling and employment falls, the central bank generally cuts interest rates and increasing the money supply to promote more growth. Conversely, when the economy is overheating and inflation runs the risk of becoming entrenched, the Fed will raise interest rates and reduce the money supply in an effort to “cool off” the economy.
h2 The History of Federal Reserve Interest Rates/h2While the Fed has always sought to smooth out the business cycle through adjusting interest rates, it’s approach to tweaking interest rates has changed substantially over the decades. As any financial historian will tell you, the Federal Reserve made many mistakes early in its history, including raising interest rates in the early 1930s and likely exacerbating the severity of the Great Depression.
The modern history of Federal Reserve interest rate policy can be properly dated back to 1982. Before that period, the US monetary system was either based on the gold standard (pre-1933), a pseudo-gold standard called the Bretton Woods system (until 1971), volatile unannounced changes to the Fed’s open market operations (1971-1979), or focused on adjusting the money supply, rather than interest rates (1979-1982).
Thus, though we do have reliable records of the Federal Funds interest rate dating back to the mid-1950s, it was not the unambiguous, primary tool for adjusting monetary policy that we know today until the early 1980s:
Source: FRED
h2 The Modern History of Fed Rate Cut Cycles/h2Since 1982, the Fed has generally tried to avoid surprising markets and manage expectations by publicly announcing its interest rate decisions and, more recently, sharing its current expectations for future economic variables like growth, inflation, and unemployment, as well as interest.
With the Fed seemingly on the verge of a new interest rate-cutting cycle as we go to press, I wanted to examine what has happened to major currency pairs both in the year before and year after the first interest rate cut of a cycle.
For the purposes of this analysis, an interest rate “cycle” is defined as a 100bps (1%) move higher or lower in interest rates. By this definition, there have been seven unique easing cycles since 1982, starting on the following dates:
As with any study of historical prices, there is no guarantee that future interest rate cycles will play out similarly, especially with a relatively small sample size, but this type of analysis can be a useful tool for setting expectations and identifying ranges of potential outcomes.
h2 Impact of Fed Rate Cuts on EUR/USD/h2Starting with the world’s most widely-traded currency pair, EUR/USD has seen broadly divergent returns both in the year before and year after the first Fed rate cut of a new easing cycle:
Source: TradingView, StoneX
h2 Impact of Fed Rate Cuts on GBP/USD/h2Turning our attention to British pound, GBP/USD has seen a more consistent bearish trend both in the year before and the year after the start of a new Fed rate easing cycle:
Source: TradingView, StoneX
h2 Impact of Fed Rate Cuts on USD/JPY/h2When it comes to USD/JPY, the returns around Fed rate cuts have been variable, with a slight positive average both in the year before and after the start of a new easing cycle:
Source: TradingView, StoneX
h2 Impact of Fed Rate Cuts on the US Dollar Index (DXY)/h2Using the US Dollar Index (DXY) as a broad measure of the value of the world’s reserve currency, we can draw the following general conclusions:
Source: TradingView, StoneX
h2 How do Fed Rate Cuts Impact the Forex Market?/h2Perhaps contrary to popular opinion, the start of a new Fed rate cut cycle has NOT been a consistent bearish catalyst for the US dollar; if anything, the historical track record shows a modest bullish trend in the greenback, especially in the six months before and six months after the Fed starts easing policy.
Time will tell if future cycles follow the historical tendencies, but by better understanding the range of potential outcomes, readers can plan their outlooks for the coming year+ with more confidence.
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