US Federal Reserve's new direction and what it means for the dollar's valuation

Heading into Wednesday's (20 September) US Federal Reserve decision, there was the usual element of caution in markets but underneath all of this, there was a sense of confidence about how it would play out. As ever, Fed Chair Janet Yellen and her colleagues had a surprise up their sleeves.

The US central bank announced that as of October, it would begin unwinding its near $4.5trn balance sheet, starting with monthly reductions of no more than $10bn which will rise quarterly for a year until hitting $50bn per month.

This is in line with the plans laid out in June, and as previously, investors have shrugged their shoulders in response.

It is also a more than welcome response from the Fed's perspective as they once again re-enter experimental mode.

With investors clearly not too interested in the Fed's balance sheet reduction plans (yet), it was over to its economic projections for what was expected to be a dialling back in rate hike expectations and a signal that the previously forecast third hike of 2017 is no longer likely.

The problem being that not only does it remain very much within the Fed's projections, but support for it has grown from 8 out of 16 policy makers in June to 11 this month.

And herein lies the reason why the dollar spiked in the immediate aftermath of the release and why yields on 10-year Treasuries reached their highest since 8 August. Suddenly, that rate hike that looked increasingly unlikely in December for a range of reasons – lack of inflation, fiscal stimulus delays, hurricanes to name a few – is both back on the table and gaining support.

The probability of at least one rate hike this year, according to CME Group, has risen to 78% from 58% prior to the meeting.

Interestingly, looking beyond December, the divide between the Fed and the markets once again becomes very significant. One rate hike by November 2018 is not even 50% priced in according to Reuters, despite Fed projections suggesting three more will follow next year.

I think we have to look beyond the usual disagreement between Fed officials and markets to understand the substantial difference between expectations.

Yellen's current term expires on 3 February next year and, with her vice Chair Stanley Fischer having resigned, effective around 13 October, the rate-setting Federal Open Market Committee (FOMC) could look very different come the start of next year.

Should President Donald Trump appoint a more dovish leaning Chair and Vice Chair, then there may be no more hikes next year and there are certainly benefits to him doing so.

Bearing all this in mind, whether the dollar rally can be sustained in the medium to long-term may well depend more on who will be next Chair as opposed to the data.

From a short-term perspective, there is certainly scope for the dollar to build on the gains made on Wednesday and enjoy some reprieve from the miserable year it's had so far. The dollar index is down more than 10% from its 2017 high hit on 3 January.

With the European Central Bank doing everything in its power – without abandoning tapering plans – to cap the upside in the euro against the dollar and the greenback making positive moves against the yen, Aussie dollar, kiwi dollar and the loonie, there is certainly reasons to be bullish on the US currency in the near-term.

Whether that can be sustained or not is a different question altogether.

Craig Erlam is senior market analyst at foreign exchange and financial services provider OANDA, a company he joined in 2015. With years' of experience as a financial market analyst and trader, he focuses on both fundamental and technical analysis while conducting macroeconomic commentary.