Should you buy or sell the US dollar ahead of a historic rate hike?

In a few hours from now, the Federal Reserve of the United States is forecast to hike the funds rate by 50 basis points. It would be the first time since 2000 that the Fed will hike by more than 25 basis points.

Hence, if delivered, it would be a historic rate hike. But what does it mean for the US dollar?

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The world’s reserve currency rallied in 2022, reaching levels that many think of being overbought. At this point, the money markets have priced in 325 basis points of hikes in this cycle, which is above average compared to the past four cycles.

For instance, during the 2015-2018 cycle, the Fed hiked 225 bp. Also, during the 1999-2000 cycle, the Fed raised the interest rate by 175 basis points.

Only this time is different, for the simple reason that inflation is much higher than during past hiking cycles. Therefore, traders should keep an open mind about what the Fed wants and is willing to do.

Will the Fed target the US business cycle?

With inflation running above 8%, it is hard to believe that the Fed will not use everything in its powers today and in the upcoming meetings. As such, it will likely tighten sharper than most expect.

Also, it will likely deliver a very hawkish rethoric about future rate hikes. All these favor a much stronger US dolllar.

Furthermore, quantitative tightening, or the Fed selling the bonds it holds on the balance sheet, will further contribute to the greenback’s strength.

But then again, this should already be priced in.

What is not priced in is the possibility of the Fed targeting the business cycle. Sharp tightening of monetary policy may lead the US economy to shrink drastically over the summer.

More precisely, the housing market is in focus, when interest rates rise.

Therefore, another quarter of slow or negative economic growth would make the Fed pause int tightening after summer. That is especially true if inflation starts coming down as well.

For now, dollar bulls are comfortable. Rate hikes and hawkish rhetoric should help the dollar, but those looking for investing for the medium and long term, may have a different opinion about today’s outcome.