After a particularly hawkish conclusion from the October 2015 U.S. Federal Reserve meeting, the markets are at least preparing for the real possibility that December 2015 could finally be the time when interest rates see an uptick. Rising rates have far-reaching implications for the U.S. and global economies. Rising interest rates tend to get a bad reputation due to the fact that borrowing and loan costs usually see an increase, thus directly affecting consumers.
From this standpoint, rising rates may make bigger purchases, such as houses or cars, more expensive, but rising rates also signal there is a positive outlook on the economy and growth is expected to continue. This vote of confidence can help spark more corporate spending and hiring down the line as business confidence also rises. While rising interest rates affect many aspects of the economy, how do they affect the value of the U.S. dollar?
Rising Interest Rates Prove to be Bullish Events for Currencies
In terms of government economic reporting, one of the most important and impactful reports on currencies is interest rate decisions. Along with gross domestic product (GDP), trade balance and unemployment figures, interest rate decisions have the ability to cause significant moves in the currency markets. However, when looking at the U.S. dollar’s performance after the Federal Reserve raised rates from 1990 to 2015, rate increases and their correlation to the U.S. dollar have certainly weakened and gone against the traditional phenomena.
In 1994, the Federal Reserve began increasing rates and then watched as the dollar sank through the beginning of 1995. By the time the next round of interest rate hikes came in 1997, the U.S. dollar was beginning a rally that would last through 2001. The last rising rate cycle between 2003 and 2006 was sandwiched between two recessions, and subsequently, the U.S. dollar lost value during that cycle. In short, while rising rates traditionally are very bullish for currencies, due to the fact that investors are able to obtain higher carry interest, the U.S. dollar and federal funds rate increases over the past 25 years have had a nontraditional low correlation.
U.S. Dollar Not Likely to See Major Move During Next Rate Increase
When the Federal Reserve once again enters a rising rate cycle, do not expect the U.S. dollar to sustain a substantial move. For one thing, as mentioned above, U.S. rate increases have had low to negative correlation with the U.S. dollar, and the U.S. dollar has already sustained a massive rally since late 2014. Since late last 2014, the U.S. dollar index has rallied from around $81 to its current $97.59 in November 2015. At one point, the index was above $100. This is a substantial move in the currency markets, as investors have been highly anticipating a rate increase for the past year. Analysts and market pundits have continually reiterated there is a strong likelihood the dollar’s response to a rate increase could be relatively muted.
The Bottom Line
The bottom line is the United States has been in a record low interest rate environment for almost eight years, and the U.S. economy’s sluggish growth actively reflects the current environment. Rising interest rates signal more confidence in the economy, but do not be fooled; rising rates are shown to have less correlation with the U.S. dollar over the past couple of decades. Tie in the fact the U.S. dollar has already seen a massive rally since late 2014 and this leads to the likelihood that investors who are betting on another sustained leg higher in the U.S. dollar rally are likely to be sorely disappointed.
