The price of money affects everything financial. When the price changes, so does everything else, including perceptions. Relationships adjust, risk-reward dynamics move, and investors rethink, recalculate and review.
Evolution on this plane usually moves at a snail’s pace over a day or two, only to reveal itself more fully in longer stretches, with the repercussions rippling across asset classes, markets, and borders. So, when the Federal Reserve raises interest rates for the 15th time in a row, as it did on Tuesday, and the dollar reacts by slipping, you may wonder what Mr. Market is thinking.
The U.S. Dollar Index is lower this morning, despite this week’s 25-basis-point bump in Fed funds to 4.75%. In fact, the Dollar Index is considerably lower than compared to mid-November, a moment in time when Fed funds were a relatively slight 4.0%.
Higher interest rates and a falling dollar. What gives?
In theory, higher interest rates imply a stronger currency. In a make-believe competitive world, with only those two variables defining capitalism, capital consistently flows to the higher-yielding currency for the simple reason that higher beings prefer profits that are bigger rather than lesser. Of course, the global economy has more than two variables determining outcomes, and the dollar is subject to any and all of them. The trick is figuring out which variables dominate at the moment, and for the foreseeable future.
We can begin searching for an answer by observing that interest rates seem to carry less potency as a buck-boosting stimulant these days. That could change in six minutes, but for now this is our story and we’re sticking to it. This despite the fact that Fed Chairman Ben Bernanke has all but assured us that yet-another rate hike is coming in May, when the FOMC meets again.
In truth, there are no absolutes in forex trading, the world’s biggest marketplace and the one that’s subject to more macroeconomic factors than any other. As a result, it’s easy to see what you want to see when it comes to predicting the future path of the dollar.
The pessimists see a dollar ultimately succumbing to the twin deficits that hound the American economy–i.e., the red ink on the trade and federal-budget ledgers.
In contrast, the optimists say that America’s relatively robust economy, driven by heavy doses of free-market incentives, will carry the day, keeping the buck stronger than it would otherwise be in a more state-controlled environment.
Within those two extremes lie a rainbow of variety, some of it as nuanced a Congressional budget. Consider, for instance, one outlook for the dollar that calls for a strengthening buck and a weakening U.S. economy. A weaker economy suggests lower interest rates, and so a lower dollar. But the burning desire, particularly in Asia, to export goods to the U.S. will prop up the buck regardless, and keep long rates lower than they otherwise would be. Or so some analysts figure.
If that argument fails to impress you, there are other choices to consider, some with bearish implications for the buck. That includes the fear that the explosion of petrodollars, primarily in the Mideast, will find paper alternatives to the dollar more alluring in the years ahead. A smoking gun leaning in that direction comes to us by way of the United Arab Emirates central bank, whose governor reminds this week that he’s intent on upping its euro-based reserves to 10% from 2%, coming at the expense of the dollar. Translated: sell the greenback. “Although the potential shift in reserves by the UAE does not represent a huge amount on its own, if this becomes a trend throughout the region it will have a significant impact on currency markets,” advise currency analysts from BNP Paribas, via Marketwatch.com.
In fact, an unprecedented rise in foreign reserves among central banks generally, especially among emerging market economies, is creating a massive pool of liquidity that carries new-found power to move currencies and interest rates. Unfortunately, the implications are less than clear, in part because the central banks behind the trend don’t respond to the same set of risk/reward factors that inform profit-seeking individuals. The motivations of the central banks may be fuzzy, but their influence is large and growing, suggests a February research paper from the European Central Bank. “A significant share of the U.S. current account deficits is financed by foreign official institutions pursuing objectives that are, to some extent, insensitive to risk-return considerations,” concludes The Accumulation of Foreign Reserves, No. 43.
Suffice to say, the dollar’s reaction to any future interest-rate hikes may very well be driven by trends outside the usual suspects found in textbooks. That leaves open a wide variety of possible outcomes in the land of forex, including the possibility that the dollar slumps, even in the face of additional interest-rate hikes.
If the Fed can’t support the dollar by tightening the monetary strings, what options are left for the central bank in a world where precedent’s under constant threat of extinction?