Backtest Study: How Does USD Behave Before and After the Fed Raises Rates?

12/11/2009 12:01 am EST

Focus: FOREX

Kathy Lien

Managing Director and Co-Founder BKForex LLC, BK Asset Management

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 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.

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We examined eight periods of tightening over the past three 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, three months before the Fed began to tighten, the EUR/USD was trading 2% lower. In other words, it appreciated 2% ahead of the rate hike. Three months after the Fed actually tightened, the EUR/USD was trading 1% higher, which means that after the rate hike, the euro actually strengthened against the dollar.

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Based upon our analysis, the only discernable trend is that contrary to the popular belief that a rate hike in the US 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 US 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 and euro weakness in the three months after the Fed begins to raise interest rates, as the EUR/USD either remained virtually unchanged or weakened. We also see a mild bias for dollar strength in the three 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 US dollar has performed in the past.

By Kathy Lien of

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