Fed raises interest rates 25 basis pointsOffers hawkish guidanceBut market is at peak Fed hike expectationsGBP/USD rallies above 1.31Can go higher says UOB analyst

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Pound Sterling has recovered above $1.31 in the wake of the Federal Reserve's March policy decision that saw it hike interest rates and signal as many as six more hikes are likely to fall in 2022.

The Fed met market expectations and raised interest rates by 25 basis points, while striking a 'hawkish' assessment of the outlook as members of the Federal Open Market Committee (FOMC) raised projections for where they saw the fund rate moving in the future.

But the Dollar faded, confirming suspicions the market has effectively saturated its hike expectations, thereby offering diminishing returns for Dollar bulls.

"A hawkish FOMC saw the 2022 median Fed Funds target rate dot climb to indicate seven hikes this year, and almost four next year with the projected median rate ending at 2.8%," says Alvin Tan, a strategist at RBC Capital Markets.

The Pound to Dollar exchange rate rose 0.42% in the hour of the announcement and is at 1.3162 at the time of writing on Friday, confirming the Bank of England's decision to raise interest rates on Thursday has been a largely neutral development for this pair in the near-term.

"GBP/USD jumped 0.8%, its biggest daily gain since last July and closed at 1.3149," says strategist Quek Ser Leang at UOB Bank.

The pair had been as low as 1.30 on Monday.

"The US dollar gave up initial gains after the Fed rate hike and closed lower against most of its G-10 peers," adds Leang.

The Fed said the war in Ukraine had exacerbated inflationary pressures while economic activity and employment continue to strengthen. "Job gains have been strong in recent months, and the unemployment rate has declined substantially," read the statement.

Fed forecasts now show the funds rate will be at 1.9% by year's end, which would mean a hike at each of the remaining central bank meetings this year (unless one meeting took in a 50 basis point rise).

Above: FOMC participants’ assessments of appropriate monetary policy: Mid point of target range or target level for the federal funds rate.

GBP/USD reference rates at publication:

Spot: 1.3160High street bank rates (indicative band): 1.2700-1.2793Payment specialist rates (indicative band): 1.3043-1.3070Find out about specialist rates and service, hereSet up an exchange rate alert, hereThe chart meanwhile implies at least another three rate hikes next year.

A potentially bearish reading - from the Dollar's perspective at least - is the FOMC's median estimate of the long run policy rate was lowered from 2.5% to 2.375%.

The profile is therefore one of frantic hiking early in the cycle and then a notable pause.

Research finds that the Dollar traditionally rallies into the first rate hike of a Fed tightening cycle but tends to fall thereafter.

"History says sell USD on the first Fed rate hike. It’s a sample size of four, so clearly not a statistical truth or anything, but logical. It is classic buy the rumor / sell the fact," says Brent Donnelly, CEO of Spectra Markets.

If this broader pattern is repeated then the Pound-Dollar might have bottomed for this cycle.

Looking at the short-term picture for the Pound-Dollar exchange rate, Leang says the rapidly improving momentum in the pair is likely to lead to further Sterling strength.

"In view of the overbought conditions, any advance in GBP is unlikely to challenge the major resistance at 1.3220 (minor resistance is at 1.3180). Support is at 1.3125 followed by 1.3090," he says.

Image courtesy of UOB.

On a one to three week view Leang finds a "weak phase has ended; strong rebound has scope to extend to 1.3220."

He says a "weak phase in GBP" trading started about three weeks ago but has ended as Sterling-Dollar rose above strong resistance at 1.3140.

"The strong rebound has room to extend to 1.3220. A break of 1.3220 is not ruled out but at this stage, the odds for a sustained rise above this level are not high. Overall, GBP is expected to trade on a firm footing as long as it does not move below 1.3040 within these few days," says Leang.

The Dollar's downside response to the Fed guidance could in part lie with a downgrade to GDP forecasts where new projections showed a significant revision lower to 2.8%, from 4.0% in the December projections.

A further slowdown to 2.2% was forecast for 2023.

Inflation expectations for 2022 were revised sharply higher to 4.3% from 2.6% previously, suggesting the U.S. economy was entering stagflationary territory. But unemployment is still expected to fall to 3.5% by the end of this year and remain there through 2023.

"Most members see slower growth and lower inflation once the current supply chain and pandemic-related inflation has passed," says Khatija Haque, Head of Research & Chief Economist at Emirates NBD.

Haque observes a wide range for rates projections - as per the above dot plot graph - both for this year and next with the 2022 outlook, showing 1.4% at the bottom end and more than 3% at the top while in 2023 the range extends from 2.1% to 3.6%.

"The divergence in views suggests that the Fed’s outlook on inflation and the appropriate policy response may not be strongly unified," says Haque.