Profit from Diverging Monetary Policies

How can a currency trader profit from diverging monetary policies of the major world economies? The United States Federal Reserve finally ended its stimulus program and is expected in the near future to raise interest rates. As noted in Reuters stocks were a bit lower following publication of the Fed minutes.

Stocks were down slightly Wednesday afternoon following minutes from the most recent Federal Reserve meeting as investors weighed expectations of when U.S. interest rates may rise.

Minutes of the U.S. central bank’s Oct. 28-29 meeting, where policymakers decided to finally end their bond-buying stimulus, indicated a debate among policymakers over the outlook for inflation and the economy.

Following the release of the minutes, U.S. short-term interest-rate futures traders were still betting on a first Fed rate hike by September next year.

The point is that raising interest rates may bring stocks down a bit as paying interest on loans a cost of doing business. However, raising interest rates in the USA will drive up the value of the US dollar in relation to other currencies. Not all nations are raising interest rates. In fact, with recession in Japan and another recession threatening in Europe it can be expected that rates will fall in both economies. So, how can a Forex trader profit from diverging monetary policies?

There Is Already Movement

The Federal Reserve and other central banks are in divergence mode and for good reasons. The EU and Japan are in or flirting with recession and the USA is moving further out of economic troubles. The US Federal Reserve is expected to raise interest rates to hold back inflation while Japan and Europe may be forced to open credit even farther with lower rates.

The dollar hit a seven-year high against the yen on Wednesday ahead of Federal Reserve minutes that could shed more light on the divergence in monetary policy between the U.S. central bank and its major global peers.

The yen was on the defensive, falling to a six-year trough against the euro, after Japanese Prime Minister Shinzo Abe postponed a sales tax hike in a move seen as supportive for stock markets but negative for the Japanese currency.

The dollar rose as high as 117.65 yen, its highest level since October 2007, and was last trading at 117.55 yen, up 0.6 percent on the day. The euro was up 0.7 percent at 147.515 yen, its highest since late 2008.

The effects of diverging monetary policies are already being felt. Although the Fed merely ceased buying bonds this last month they are likely soon to start inching up borrowing rates which will in turn drive up the dollar. How to profit from diverging monetary policies may well be to buy dollars and short both Yen and Euros now, before rates actually do go up.

Capital Flow into the USA

As Europe, Japan and China lower interest rates the dollar will go up. Besides simply buying dollars to profit from this rise one can also invest in the USA and US markets prior to the real rally of the dollar. Seeking Alpha has an insightful article about the dollar bull market and global equities.

US has emerged from the great financial crisis in better shape than its developed counterparts and the dollar is set for major bull run.

Evidence shows strong correlation between dollar rallies and outperformance of global equities.

European Healthcare and Pharma sector is one of the best ways to play the theme, given their dollar earnings and stand to benefit when Euro weakens.

After being in the back seat for much of the 2000s, the US dollar is back in action and at multi-year highs against the euro and yen. Improving US economy would push the dollar higher as the Federal Reserve (Fed) looks poised to raise interest rates in 2015. The recent policy divergence of lower rates in eurozone, Japan and China, would lead to more capital allocated to the US markets. Moreover the rising US energy independence would reduce oil imports and shrink global supply of dollars (from lower current account deficits).

There may be several ways to profit from diverging monetary policies. The best way to start is to realize that a stronger dollar is coming and that lots of other currencies and things denominated in those currencies will seem cheap. And, a strong dollar will attract capital and further stimulate the US economy and cause the Fed to further raise interst rates, etc. etc.