Can A Fed Interest Rate Hike Save The Dollar?

The dollar has been trending to the downside, particularly since the new COVID vaccines have been announced.

As the economy recovers, one typically does expect safe havens like the US dollar to depreciate a bit. But there are several issues that make it especially likely, which is why there are so many analysts and economists predicting a weaker dollar at least for the next few months.

One of the reasons can seem somewhat counterintuitive. And it certainly goes against what many traders might see as common wisdom: inflation.

If inflation is expected to increase, then we could also expect the Fed to raise rates. Higher interest rates translate to a stronger dollar, right?

I mean, there was this whole thing for years where Trump was pushing for lower rates to weaken the dollar.

Why would we expect a weaker dollar if the Fed is more likely to increase rates?

To fully answer this question, we have to take a peek into bond markets.

When it comes down to it, it’s the interest rate paid on government bonds that provides the swings in the value of a currency, and particularly the dollar. Bonds are relatively long-term investments.

Sure, you can buy and sell them at any time, but the value of a bond is determined by how much of a return on investment it pays over its lifetime. With bonds being measured in years, that means the depreciation caused by inflation needs to be taken into consideration.

Not all money is the same

If the bond pays, for example, 2% interest, and inflation is at 1.5%, it means that the real rate of return on the bond is just 0.5%. This makes it a less attractive investment.

When market makers move money from one currency to another, they don’t just leave it in cash. They buy bonds, which have all the advantages of cash, but also pay interest. It helps offset inflation.

Monetary policy works by allowing inflation to rise, lowering the rate of return on bonds, so people are encouraged to seek investment return in other assets. Like the stock market.

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