There are plenty of threats out there that could mean that a Fed pause or cuts reflect a very bad turn of events that send the dollar soaring.

There is clearly some debate about just when the Fed might think that it has hiked rates enough. If the median forecast of FOMC members proves accurate and the Fed hikes one more time on May 3rd, then this could also be the time when the Fed suggests that it is done. Of course, it could come later, and possibly only after more rate hikes. But we’re not so interested in when the pause may be in this piece but, instead, how the market will react when it happens. For instance, can we expect a pause to produce a significant reaction in the dollar?

On one level, the answer might seem to be ‘no, given that others have paused, such as the Bank of Canada and the Reserve Bank of Australia, and yet their currencies have not moved too far. However, Mr. Steve Barrow, Head of Standard Bank G10 Strategy, said there would be two points here.

The first is clearly that the Fed is the key global central bank, not the BoC or RBA, and hence we can expect a much greater global impact, including on the dollar, when the Fed pauses.

The second issue is whether the markets perceive a Fed pause as not just a pause but a clear end to the rate-hike cycle. There has already been some talk that the RBA and BoC may have to start rate hikes again, and if a similar sentiment is seen with respect to a Fed pause, then the impact on the market might not be very significant. However, at this point, we do think that the market will decide that a pause in Fed rate hikes is really the end of the cycle, and even firmer-than-expected data on the CPI or labor market won’t change this perception.

In theory, at least, this would seem to set the dollar up for a significant fall when the Fed pauses. However, there are a couple of caveats here as well. The first is that the market has clearly been building up to a Fed pause, and by the time it happens, we might find that it is so heavily discounted that all the dollar bears have already sold, leaving few to take the dollar much further. The second is that the reaction in the currency market will depend heavily on the context in which the Fed pauses. Here we might use the terms "benign pause" and "malign pause".

"A benign pause will happen if the Fed ends its rate-hike cycle because it has engineered sufficient declines in inflationary pressure without endangering the economy too severely. Here, we’d expect riskier asset prices to be strong and for the dollar to fall. But there is also the possibility of a malignant pause. This one happens because either the rate hikes to date have crashed the economy and risk assets, or because one of a number of significant risk factors out there, such as a banking crisis, a failure of the debt ceiling in Congress, or an as-yet-unknown risk, creates a huge risk-off plunge in riskier assets. In the malign scenario, the dollar would most likely surge on a rate pause or even on quick rate cuts. That’s not because of the cuts themselves, but because the adverse risk climate would create safe-haven demand for the dollar. We have clearly seen this playbook before when rapid Fed easing cycles have been associated with significant dollar strength, at least initially, and not weakness", said Mr. Steve Barrow.

Right now, many might see the possibility of a malign Fed pause as about the same, if not greater, than the possibility of a benign pause. After all, as we’ve mentioned, there are plenty of threats out there that could mean that a Fed pause or cuts reflect a very bad turn of events that send the dollar soaring. However, a benign pause is moderately more likely than a malign pause, and, for that reason, it is more likely that the dollar will fall. This being said, we do see the extent of dollar weakness on a benign pause as materially smaller than the dollar surge should the Fed have to deliver a malign pause or even a malign easing of policy.