USD Gains on Higher Interest Rates

The long anticipated increase in interest rates by the United States Federal Reserve has happened and, as expected, the USD gains on higher interest rates. Bloomberg Business reports as the dollar gains.

The dollar climbed against the euro and yen after the Federal Reserve raised interest rates for the first time in almost a decade, adding to the allure of assets denominated in the U.S. currency as it ends an unprecedented period of near-zero rates.

The greenback climbed after swinging between gains and losses against its major counterparts as the Federal Open Market Committee said that the pace of subsequent increases will be “gradual” and in line with previous projections. The decision comes after months of signaling that the central bank was approaching liftoff.

The key language here is the word “gradual.” The Fed is raising short term rates by a quarter percent and then they will wait to see what happens. Other rate increases will only happen if and when the Fed is ready. Nevertheless, the USD gains on higher interest rates for the time being.

How Fast and How Far Will Rates Rise?

FxStreet reports on the rate rise and notes that the Fed rate hike is being viewed favorably and that further increases will depend on how this one goes.

The actual pace of tightening will remain data dependent. As Fed Chair Yellen had previously highlighted in the speech from earlier this month, the Fed will carefully monitor “actual” and “expected” progress toward their inflation goal. From this perspective it is notable that the inflation projections for next year were lowered marginally but the median Fed funds rate projection was left unchanged which we view as a hawkish signal as well.

Forex traders as well as the Fed will be watching how this works out.

How Will Interest Rates Affect Other Currencies?

The obvious answer is that higher rates make a currency more valuable in the Forex market so the dollar will go up fractionally and all other currencies will fall by the same fraction. But, there is the issue of capital flight as capital moves out of struggling economies and into USD, YEN, GBP or EUR. It is our opinion that in this case the effect of USD gains on higher interest rates may be multiplicative and not just fractional. China is a case in point. It currency is likely to fall steadily over the next months and anyone with the ability is likely to pull assets out of China compounding the problem. The Hong Kong Standard reports that the Yuan falls to its lowest level since 2011.

The yuan closed weaker against the US dollar yesterday, after the People’s Bank of China again set the midpoint at its lowest level in more than four years, and traders anticipated the currency will fall further.

“The yuan was trading narrowly intraday, as the authorities appeared to want to control the pace of its depreciation,” said a dealer at a foreign bank in Shanghai.

Every day during the past week, the yuan has edged down about 100 pips at the open. According to the dealer, this has prompted some state-owned banks to start offering US dollars, which caused the unit to move within a narrow range intraday.

The yuan has weakened for eight consecutive sessions. Prior to yesterday’s market opening, the central bank set its official midpoint rate at 6.4559 per dollar its weakest level since July 2011 and 0.1 percent weaker than the previous fix of 6.4495.

In short the effects of USD gains on higher interest rates may be multiplied by events elsewhere.