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How the U.S. Dollar is Affected by Changes in Interest Rates

How the U.S. Dollar is Affected by Interest Rate ChangesThe US dollar is the world’s premier reserve currency. It is the most traded, watched and followed currency, and for good reason.

The US economy ranks #1 in terms of sheer size, followed by China at #2. When ascertaining the value of the greenback, there are several measures used to do this. These include currency exchange rates, Forex reserves held by governments around the world, and treasury notes. In all three categories, the USD trumps the competition.

In fact, the importance of the US dollar has been increasing since 2011 for a myriad of reasons. For starters, the global financial crisis that was precipitated by the subprime mortgage crisis in the US resulted in a rush for USD. Emerging markets suffered immeasurably after the recession hit, as investors pulled their funds out of relatively risky EM economies to the safe-haven domains of the US, Canada, Australia and Europe.

When volatility increases, investors hedge with US treasuries. These are widely regarded as some of the safest investments in the world given that the US government is unlikely to default on its payments.

What about other countries around the world? Are these governments as robust and reliable as the US government?

Yes. Many countries around the world offer equivalent safety and security in terms of investment opportunities. However, Europe has been beset by tremendous difficulties of late, notably two major crises in a possible Grexit (Greek exit from the European Union), and the Brexit (British exit from the European Union).

These events have rocked the stability of the European financial and political system to the core, making EU-denominated securities a riskier proposition. Additionally, the European Union is plagued by historically low interest rates, deflation and stagnation. The European Central Bank, headed by President Mario Draghi is feverishly trying to boost economic activity through a robust quantitative easing program.

Quantitative easing is bad for the EUR since it floods markets with the currency to accelerate the velocity flow of money. The EUR has weakened dramatically because of Mario Draghi’s €60 billion per month QE policy program which is set to run through December 2017, possibly beyond.

Japanese Yen remains a favourite hedge currency for weakness in Asia

Then of course, there are countries like Japan and China. The Asia-Pacific region has also been subject to tremendous volatility in recent years, notably the massive selloff in the Shanghai composite index and the Shenzhen composite index in 2015/2016.

Recall that China’s massive economy contracted from the vaunted 7% benchmark for GDP to 6.7%. The slowdown in China’s economy was evident in reduced demand for commodities like iron ore, steel, copper and other raw materials.

This directly impacted countries like Australia, Brazil, South Africa, Russia and others which are commodity suppliers to the world’s #2 biggest economy. The contraction reverberated globally and led to lower trading volumes and lower commodity prices in 2016. That, coupled with the oil price crunch over the past year have also put paid to robust economic growth in many regions.

It should be noted that the Japanese Yen is a hedge currency when economic uncertainty grips Asia. Traders tend to flock to the JPY as a hedge against weakness in the CNY, HKD and SGD. All of these currencies are directly affected by the strength of the USD.

Fed FOMC Moving Towards Interest Rate Target

We have seen some notable changes to the way central banks operate in the US and elsewhere. While the US is busy with quantitative tightening (raising interest rates and decreasing the money supply) countries like Japan, Canada, the UK, and the European Union are moving in the opposite direction. They have embarked upon aggressive quantitative easing programs to make it cheaper to borrow funds for investment purposes. The Chinese and the Japanese are purchasing USD at a furious rate; this is used for export purposes and to bolster their own currencies. Right now, the Fed is in the midst of hiking interest rates towards 3% by 2019.

Saxon Trade expert, Ronald Bellwether believes that the Fed plan is working effectively:

“This ambitious objective is part of an economic plan to prevent the US economy from overheating as the US unemployment rate falls to 4.3%, and inflation steadily rises. As interest rates rise, so demand for the USD increases because there is more to be gained from investing in US securities, fixed-interest-bearing investments, and the like. This also impacts the price of dollar-denominated commodities like gold, crude oil, iron ore and copper.”

A stronger USD means that it is more expensive to purchase the equivalent amount of commodities in USD for foreign buyers. For now, currency traders are positioning themselves strategically for a long-term uptrend in the USD, while emerging market economies like South Africa and Brazil face the prospect of recessionary fears.