Dollar off as Fed minutes suggest pause ahead

The dollar fell against the euro on Tuesday as interest rate differentials dominated market activity.

First, the euro pushed higher as investors discounted dovish talk from the European Central Bank. Then, the single currency gained further in the US afternoon as the dollar fell after the market read tentative signs of a pause into the Federal Reserve’s latest minutes.

Market participants dwelt on the Fed minuting of the fact that “some members cautioned that risks of going too far with the tightening process could also eventually emerge.”

By late trade in New York, the euro was at $1.182 against the dollar, from $1.174 ahead of the minutes and $1.1686 in the European afternoon.

The dollar tracked US Treasury yields, which dropped smartly as investors priced in a growing sense that the end of the Fed’s tightening cycle was in sight.

However, a number of analysts cautioned against reading too much into the minutes, given the number of comments about rising inflation also contained in the report.

Michael Woolfolk at Bank of New York noted that the line about the risk of going too far was immediately preceded by ”all members believed it important to continue removing monetary policy accommodation in order to check upside risks to inflation and keep inflation expectations contained, but noted that policy setting would need to be increasingly sensitive to incoming data.”

“The expected pace of tightening remains unchanged, and the level at which the Fed is likely to pause has also remained unchanged,” said Mr Woolfolk. “What will soon change is the explanation for further rate hikes.”

Earlier in European trade, the focus had also been on interest rates, but there watchers seemed to shrug off central bank policy signals.

Guy Quaden, a member of the ECB’s governing council, appeared to endorse the words of Jean-Claude Trichet, the president of the ECB, who said on Monday that next week’s widely expected eurozone rate hike would not necessarily be the start of a trend.

“What we have to do is to take our foot somewhat off the accelerator pedal. The question is not, for the time being, to step down on the brake pedal,” Mr Quaden said.

But few in the market seem to believe the message that one solitary rate rise may be sufficient to curb inflationary pressures.

Hans Redeker, head of currency strategist at BNP Paribas, pointed out that neither the ECB, nor the Bundesbank before it, have ever raised or cut rates just once in a cycle, with rate rise cycles in the 1970s and 1980s averaging 500 basis points and even the last tightening cycle in 1999-2000 amounting to 225 basis points. Furthermore, an ECB bulletin in May 2004 estimated that neutral interest rates for the 12-member bloc were 4 per cent, double today’s rate.

Mark Austin, chief currencies strategist at HSBC also saw ECB tightening as unlikely to be a one-off event, arguing a 25-basis point hike would still mean real rates were negative, “a condition authorities clearly want to move away from”. Mr Austin sees ECB rates hitting 2.5 or 2.75 per cent.

Mansoor Mohi-uddin, chief forex strategist at UBS, joined in , saying: “For now our economists continue to argue for a series of rate hikes into next year and the market may view Trichet’s comments with a healthy dollop of scepticism.”

The Canadian dollar also rose 0.5 per cent to C$1.1768 against the greenback despite the release of soft inflation data, with core prices flat in October. The figures were not seen as enough to deter the Bank of Canada from raising interest rates in December.

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