Interest rates are the critical factor determining the path of least resistance of one currency versus others. Central banks and government hold reserve currencies to meet payment obligations. Moreover, the monetary authorities often intervene in currency markets to create stability in the foreign exchange instruments that derive value from the full faith and credit of the governments that issue legal tender.
Fiat’s definition is “a formal; authorization or proposition; a decree.” Fiat money has value based on little more than a decree from the issuing government that it has value as legal tender. Fiat currencies depend on faith and credit, and the rise of cryptocurrencies over the past decade has been a barometer that faith and credit by the masses have declined.
Meanwhile, rising interest rates in one fiat currency versus another tend to increase the money with the higher yield’s value. The dollar is the world’s reserve currency. As the US central bank prepares to address the highest inflation levels in four decades, the prospects for higher US interest rates have pushed the dollar to higher lows and higher highs against other world fiat currencies. However, the ascent of the US foreign currency instrument could be little more than a mirage as the currency market only measures one fiat against others.
US interest rates will rise in 2022 - The only question is how much?
- Quantitative easing will end in early March.
- The Fed is set to increase the Fed Funds rate by 25 or 50 basis points at the March FOMC meeting.
- CPI, PPI, and the latest jobs data support rate hikes.
- January job gains came in far above the market’s expectations.
- Bank of America has the most aggressive rate hike forecast, calling for seven hikes that would take the Fed Funds rate to 1.75% by the end of 2022.
The dollar index has been rallying on the prospects of higher interest rates
- The US dollar index measures the US currency against other world reserve currencies with the highest exposure to the euro.
- Higher US interest rates pushed the dollar index to 97.44 on January 28, the highest level since June 2020.
- While the dollar index corrected to the 95.50 level at the end of last week, the trend remains bullish as the index has made higher lows and higher highs since January 2021.
A bullish dollar does not support profits for US multinational companies
- A rising dollar makes US goods and services less competitive on worldwide markets.
- The previous administration favored a weak dollar to use as a tool in trade negotiations.
- The current administration favors a strong dollar policy.
- A rising dollar tends to weigh on raw material prices as the US currency is the pricing mechanism for most global commodities.
The US dollar is a fear barometer
- The dollar tends to rise when fear and uncertainty grip markets.
- As the world’s reserve currency, the dollar is stable and attracts buyers seeking safe harbor during turbulent times.
- During the initial days when the 2020 global pandemic gripped markets across all asset classes, the dollar index spiked higher to 103.96, the highest level since 2002.
Three reasons why we should expect the unexpected in markets in the current environment
- 2022 is no typical year as the world continues to face the pandemic.
- Reason 1: Even if the Fed increases the Fed Funds Rate seven times to 1.75% in 2022, interest rates will remain in negative territory if inflation does not substantially decline.
- Reasons 2: Geopolitical pressures surrounding Ukraine, Taiwan, North Korea, Iran, and other regions could cause lots of volatility in markets across all asset classes, including the US dollar. The Fed does not have the latitude to add liquidity to markets as the swollen balance sheet contributes to inflationary pressures.
- Reason 3: The mid-term elections will highlight the political divisions in the US, which could lead to two years of gridlock before the next Presidential contest in 2024.
It is the Chinese New Year, and an old Chinese saying, which many consider a curse, is “May you live in interesting times.” The year of the Tiger is undoubtedly a treacherous and volatile time in the world, and markets reflect the political and economic landscapes. Fasten your seatbelts as market turbulence is likely to continue and even accelerate over the coming weeks and months.
Thanks for reading, and stay tuned for the next edition of the Tradier Rundown!