Here's how UBS expects the US dollar to react to potential Fed rate cuts

Investing.com -- A 25-basis point interest rate cut by the Federal Reserve would drive a "knee jerk" rebound in the US dollar, while a 50-basis point reduction would weigh on the greenback, according to analysts at UBS.

The Fed is widely anticipated to slash interest rates for the first time since March 2020 following the conclusion of its latest two-day meeting on Wednesday, but the scope of the reduction remains a source of considerable uncertainty for investors.

According to CME Group's (NASDAQ:CME ) closely-monitored FedWatch Tool, the chances of a jumbo 50-basis point cut -- rather than a more traditional 25-basis point drawdown -- stand at 65%.

Bets that the Fed will roll out a jumbo drawdown have increased in recent days, fueled by reports in the Financial Times and Wall Street Journal that the move is still a possibility. Meanwhile, former New York Fed President Bill Dudley has said there is a "strong case" for a deeper cut, arguing that borrowing costs are currently well above the so-called neutral rate which neither restricts nor accommodates economic activity.

In the final data point before the announcement, US retail sales unexpectedly rose in August, pointing to consumer resilience and broader economic strength. Such trends, along with mixed recent inflation figures and loosening labor demand, could further complicate matters for Fed officials.

But in a note to clients, the UBS analysts said the decision itself is just one aspect of a Fed announcement that will also include an updated look at policymakers' rate projections, a possible "overhaul" to the Fed's official statement, and a press conference with Chair Jerome Powell.

Traders will likely be hunting for any insight into how the Fed plans to approach a possible easing cycle, with markets currently expecting at least 100-basis points in cuts by the end of 2024.

For foreign exchange markets, the UBS analysts said the key point of focus is "whether the combination of policy elements in play will be seen as consistent with the priced in view that an acceleration in the pace of rate cuts is possible."

"For this reason, while we would anticipate a 25-[basis point] cut to drive a knee jerk USD rebound, we also believe that said rally would lack staying power if coupled with a dot plot and/or with guidance that does not fundamentally push back against 'the spirit' of the priced in outlook for Fed policy rates," the analysts said.

Conversely, a larger half-point cut would "prove unequivocally negative" for the dollar, the UBS analysts noted, adding that the outcome may test their end-of-year targets for several of the greenback's currency pairs.

Source: Investing.com