Dove flying in blue sky

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If you are not used to traders’ tech-speak, you might hesitate when you hear words such as dovish and hawkish.

What is the Fed?

The Fed or Federal Reserve System has several roles, including:

  • Managing U.S. monetary policy by influencing money supply and credit.
  • Regulating banks and other financial institutions
  • Maintaining stability of the financial system
  • Providing financial services to the U.S. government and other U.S. and foreign institutions.

As part of this, federal funds (or fed funds) are reserves that financial institutions and commercial banks deposit at Federal Reserve banks.

The Fed can lend this cash to lend these funds to other market participants who find themselves with insufficient money to meet their obligations. The Fed charges interest on these loans and sets interest rates.

If the Fed raises interest rates, the cost of borrowing increases, so credit and investment become more expensive. This has the effect of slowing the economy.

If the Fed lowers rates, borrowing becomes cheaper, encouraging increased spending on credit and investment. This has the effect of stimulating the economy.

 Federal Reserve Bank

The Federal Reserve Bank in Washington, DC.

 

When the Fed is Dovish

When the Fed is dovish, it means that the Fed is reducing interest rates. As already indicated, the motivation for doing so is to increase the amount of cash in the economy by making borrowing cheaper.

On the other hand, when the Fed is hawkish, it means it is increasing interest rates. The reason for doing this is usually to apply a brake on or reduce inflation. It means that borrowing money will be more expensive.

There is no cut-off point between dovish and hawkish. Essentially they describe the general attitude or outlook of the Fed at that specific time.

The impact of a dovish Fed on Exchange Rates

A dovish Fed will lead to a fall in dollar exchange rates. Here we explain the impact and mechanisms of both a dovish and a hawkish Fed:

  • A dovish fed – When the Fed is dovish, investors are likely to sell assets denominated in dollars and buy assets denominated in foreign currencies. The more significant the difference between U.S. interest rates and those in other countries, the more likely it is for investors to move from dollar to foreign-denominated assets. Investors need foreign currencies to buy foreign assets, so they will exchange dollars for other currencies. As the demand for foreign currencies increases, the dollar exchange rate will fall.
  • A hawkish Fed – When the Fed is hawkish, investors are likely to sell assets denominated in foreign currencies and buy dollar-denominated assets. The greater the difference between U.S. interest rates and those in other countries, the more likely it is for investors to move from foreign to dollar-denominated assets. Investors need dollars to buy dollar assets, so they will exchange other currencies for dollars. As the demand for dollars increases, the dollar exchange rate will also increase.

Summarising this:

  • Dovish Fed – interest rates down – exchange rates fall
  • Hawkish Fed – interest rates up – exchange rates rise

Note also that the interest rate decisions made by the Fed can have a significant influence on interest rate decisions made by other countries. When decisions made by a dovish Fed leads to weakening of the dollar, the currencies of other countries tend to rise.

This is likely to hamper their export market so in response, the central banks of these countries, particularly emergent countries, would typically respond by reducing their exchange rates in unison with the Fed.

How a Dovish Fed Affects Forex Traders

When interest rates fall, the value of currency usually falls as international investors will quickly move their cash to places that offer higher interest rates.

However, just because the Fed reduces interest rates, the fall in dollar values is not automatic as there may be complex issues involved in the U.S. and world economies.

If traders had already anticipated a reduction in the interest rate, then the immediate impact on currency values would likely be less than if its decline was a surprise.

You may not be able to guess the way the Fed is going to manage interest rates but you can check out a list of trading systems that have passed a live trial here at Trade Stocks & FX here.

 

 

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