Can A Fed Interest Rate Hike Save The Dollar?

When bond yields go down, therefore, we can expect the currency to be less valuable. This is because big investors are less likely to buy bonds in that currency.

But if the Fed raises rates, then bond yields increase

That’s right, and that’s why raising rates strengthens the currency (usually). But the US is in a particular situation.

All the deficit spending (which might total up to $8.0T by the end of the year) traditionally is expected to push up inflation. Meanwhile, the Fed has said they will tolerate somewhat higher inflation in order to help the economy get on its feet.

So, if the interest paid on bonds stays the same, but inflation increases, then traders are faced with the reality that the real interest rate is actually negative.

If you are buying T-bonds that pay, for example, 2% interest, but inflation is 3%, you’re actually losing 1% a year on your investment.

It’s about the pace of rate rising

The Fed can counter this by raising rates. But, the thing is, they are very, very reluctant to do so.

Inflation is not a matter of decision. It will rise depending on the underlying economic factors. With a 40% increase in the monetary base, expectations would be for inflation to grow. Especially with the Fed signaling that they are less willing to address higher prices.

The end result is that if inflation rises faster than interest rates, then the net effect is that yields go down. Lower yields mean investing in the dollar is less attractive.

If the inflation rate goes from 1.4% to 2.4%, but the Fed raises rates only 25 basis points, then the net result is that real yields have dropped 0.75%

The Fed’s hands are tied

While it’s true that higher inflation would be expected to put pressure on the Fed to raise rates, many analysts are banking on the Fed being unwilling to raise rates fast enough.

Higher interest rates are always interpreted by the market as a sign that the Fed is on a raising cycle. And they typically slow down the economy as capital costs increase.

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