The second half of the trading year brought a very strong US dollar. Few investors expected the greenback to strengthen as much as it did in just a few months.

For example, the EUR/USD exchange rate dropped from 1.12 to 1.04 without any meaningful bounce. Or the USD/JPY exchange rate rose from 140 to 150 over the same period.

Therefore, one may say that the US dollar is “en vogue.” Investors like it.

But what if I told you that the same investors buying the dollar might be walking on thin ice? The counterargument I have has been around for centuries – interest rates.

A history of interest rates

If a picture tells a thousand words, here is one showing the decline of interest rates over the last 700 years, courtesy of Visual Capitalist.

(Click on image to enlarge)

What is of interest to today’s investors is the last two decades or so, when interest rates were more depressed than ever before – even negative in some cases. What did such an environment do to markets?

What did a low-interest rate environment mean for markets?

Interest rates move an economy. If today an investor is asked what major event impacted financial markets in the last two decades, the answers would likely be the Great Financial Crisis or the Lehman Brothers’ bankruptcy.

But the real phenomenon that impacted markets was a low interest rate environment. Central banks were forced to be activists searching for a solution to the crises mentioned above and others – e.g., the COVID-19 pandemic.

In other words, it wasn’t a typical market environment.

Due to the highly stimulative Fed’s behavior, investors were optimistic and eager to buy assets, and their only worry was the fear of missing out. After all, the credit window was wide open.

Not anymore.

Higher for longer – the new mantra

Inflation is on every central bank mandate. In the developed world, a realistic target for inflation is 2%.

Or, it was.

The new mantra we hear from the main central banks in 2023 is that interest rates are here to stay higher for longer. In other words, inflation is unlikely to come back to 2% any time soon. Therefore, a new inflation target would likely be appropriate – something like 3%?

So, interest rates are not going down (significantly) any time soon. But what happened last time when interest rates were 5% or higher?

(Click on image to enlarge)

1929 is known as the year of the Great Depression. Interest rates have hit 5%, and history’s most severe economic downturn began.

We are at 5% for the first time in a decade!

Based on the 700-year chart presented above, one question arises: what if the new trend (i.e., higher interest rates) is here to stay?

(to be continued)

More By This Author: