In countdown to Fed, traders keep eye on dollar's 2004 decline

WASHINGTON (BLOOMBERG) - With the Federal Reserve's interest-rate decision about seven hours away, currency traders are on alert for a repeat of dollar declines that followed the start of tightening cycles in 2004, 1999 and 1994 on speculation that a boost is already in the price.

Intercontinental Exchange Inc.'s U.S. Dollar Index, which tracks the greenback against six peers, halted two days of gains on Wednesday, even with futures contracts showing a 76 percent likelihood that the Federal Open Market Committee will raise its benchmark from near zero later on Wednesday.

That's because officials have spent months preparing investors for what would be the first tightening of policy in almost a decade, while at the same time stressing that future moves will be gradual.

"The Fed will continue to press home the message that it's going to be slow and gradual," said Peter Dragicevich, a foreign-exchange strategist at Commonwealth Bank of Australia in London.

"Looking back at previous cycles, we seem to be in the same sort of pattern where the market is underpricing how much the Fed could do in the first 12 months."

The Dollar Index was little changed at 98.255 as of 7:27 a.m. in New York. The greenback was at $1.0917 per euro, after rising 0.6 percent to $1.0931 Tuesday. It was at 121.83 yen.

Expected price swings against the euro overnight leaped on Wednesday to almost double their average level for the year. The implied overnight volatility jumped to 23.4 per cent from 10.7 per cent on Tuesday, and compares with a 12.2 per cent average for 2015, according to options data compiled by Bloomberg.

Fed Chair Janet Yellen has emphasized the central bank will follow a gradual path after an initial move, and futures show the federal funds rate will inch higher. The rate will climb to 0.75 per cent in a year from 0.13 percent now, according to data compiled by Bloomberg.

The last series of rate increases in the U.S. began in June 2004. The dollar index declined in five of the following six months, before a sustained rally through much of 2005.

The June 1999 rate increase was followed by a 3 percent drop in July, while weakness in the dollar index was seen in 11 of the 14 months after the February 1994 hike.

The dollar gauge declined 2.5 per cent in the two weeks ended Dec. 11, 2015.

Traders will be seeking clues on the number of interest- rate increases next year from the so-called dot plot, a chart sketching out officials' projections for where rates will be in the future. The dots will probably mean three rate increases in 2016, fewer than the four suggested at the most recent release in September, said Roy Teo, a Singapore-based senior foreign- exchange strategist at ABN Amro Group NV.

The prospect of further monetary stimulus by the European Central Bank and Bank of Japan will probably strengthen the greenback to 95 cents versus the euro and 135 yen next year, he said.

"There is still further room for the U.S. dollar to strengthen over 2016," he said. "Any temporary decline in the dollar is likely to be minimal."