The international monetary economics textbooks teach a trivial rule of thumb: a domestic currency appreciates when a central bank hikes interest rates, as it makes the financial assets denominated in that currency relatively advantageous and depreciates when the rates are lowered, for the opposite reason. This should apply in the short term, since the increase in the attractiveness of financial returns on the various asset classes is immediate.
However, the empirical evidence shows how things do not always go in this direction. We had a demonstration of this yesterday, with the meeting of the Federal Reserve, in which the U.S. central bank lowered interest rates by 25 basis points, motivating the move with the upside risk of international economic tensions, which increase the uncertainty in the economy.
If the thumb rule had been respected, the dollar would have depreciated immediately against the euro, as financial assets denominated in dollars have become relatively less attractive compared to those denominated in euro. Instead, the opposite has happened. The euro-dollar exchange rate, in fact, has come to lose up to -0.76%, touching the threshold of 1.1062.
What has happened? It has happened that the traders have not only considered the cut per se, but they have contextualized it in a wider speech made by the governor Jerome Powell, who declared that the cut is only a ‘mid-cycle adjustment’, not the beginning of a new trend. In other words, the central bank has not guaranteed that other cuts will be made this year. Traders have read Powell’s speech in a hawkish perspective and have thus made the purchases of dollars prevail due to the forecasts of a non-cutting of the rates compared to the sales due to the cut itself.
In conclusion, the strategic advice that can be drawn from this case is the following: it is always advisable not to operate on currencies before reading the statement of the central bank following the monetary policy decisions and once the document is read, it is often more important to consider the forward guidance than the decision itself.