Fed rate cut will trigger a wave of dollar selling? Not that simple!

Once the Federal Reserve starts lowering interest rates, will the US dollar definitely decline and enter a downtrend?

Generally speaking, lower official interest rates should translate into lower US Treasury yields, which, under other conditions being equal, would reduce the attractiveness of US assets. The difference in short-term interest rates is often a key factor driving currency trends.

However, investors also need to consider specific circumstances. Here is a chart from Societe Generale showing the changes in the US dollar index and the federal funds rate over the past forty years.

US Dollar Index and Federal Funds Rate

Strategists wrote:

In 1985, the US dollar fell significantly, but this occurred four months after the first rate cut.

In 1989, the US dollar quickly declined after the first rate cut, but there was a rebound between the first and third rate cuts in 1995/96.

In 1998, the US dollar began to fall before the Fed cut rates due to the collapse of Long-Term Capital Management (LTCM).

In 2000, the US dollar was already declining when the Fed began easing policy.

In 2001, the US dollar rebounded, but eventually experienced a significant decline between 2002-04 as rates continued to fall.

In 2004, the US dollar mostly fell as rates rose, although there was a rebound in 2005, it started falling again before the Fed eased policy in 2007. The only rate cut cycle since then began in July 2019, and the US dollar fell for several months and continued to fall when the COVID-19 pandemic emerged...

In 2020, the unprecedented Fed easing did lead to a significant decline in the US dollar.

The strategists concluded that if investors and traders can learn from this, it is that a prolonged period of Fed easing may weaken the US dollar, but a brief and relatively small rate cut cycle (such as in 1996 and 2019) may not trigger a significant reaction as funds will still flow into US assets.

So, what is the current situation? They pointed out that the current real peak of the US dollar is the highest level since 1984-85, slightly higher than the peak in 2002. In both the 1984-85 and 2002 scenarios, the US dollar had a delayed reaction, followed by a significant decline, both of which coincided with a period of substantial rate cuts by the Fed.

They wrote, "The current level of the US dollar, as well as the scale of positions that have brought the US dollar to this level, indicate the need for a significant adjustment. Expectations for the Fed to ease monetary policy, avoid economic recession, and the continued existence of US economic exceptionalism require us to remain cautious."