When Will Interest Rates Return to Normal?

Interest rates in the USA have been at historic lows ever since the 2008 market crash and beginning of the Great Recession. It has been just a little more than a year since the US Federal Reserve raised rates by a quarter of a percent. The Fed is poised for another rate increase that will still leave the base rate below 1%. When will interest rates return to normal and how will the USD respond? Bloomberg discusses when rates will return to the old normal.

With inflation back around 2 percent in the U.S. and the Federal Reserve moving away from its years-long policy of monetary accommodation, something like economic normality is beginning to return. But to truly get back to the “old normal,” real interest rates must play catch up, and that’s likely to take a while.

Although the new president promised economic changes he is promoting social issues first. This has the markets concerned as witnessed by options trading in Forex. The options market points to several expectations.

Options indicate that gold and other assets that do well when inflation looms are not being priced with great upside, while nominal Treasuries are now viewed more favorably.

Option prices indicate that the holders of government bonds are likely to go largely unrewarded for some time, and because the risk is now in real rates, yields on inflation-protected bonds would be expected to rise with those on nominals.

Option prices also point to good near-term growth in emerging markets and for equities in China and Mexico. Signals indicate they are compelling buys, despite Trump’s bombast about reining in nations that benefit from “unfair” trade practices. Signals indicate that changes to trade deals won’t necessarily be punitive, which suggests that Trump doesn’t plan to stifle global trade.

The Fed does not have all that many tools in its tool box and will act cautiously in raising rates. That means a few years before interest rates return to historic normal. What do Forex traders do in the meantime?

Where Is the Dollar Going?

Inflation reduces the value of the US dollar and higher interest rates raise its value versus other currencies. The dollar has been going up. Is it time to short the greenback? Seeking Alpha considers the issue.

Rising interest rates is one of the drivers for the stronger dollar. The Fed has signaled three rate hikes this year. After some disbelief recently, the March hike is priced in as nearly certain, and the other two rate hikes are now also largely priced in. Unless one expects the economy to perform better than anticipated by the Fed, there is little room left for dollar strengthening surprises here.

The stimulating effect of the pro-business policies of Trump may result in overheating the economy and rising inflation. This is one scenario where the Fed is likely to rise interest rates more than the signaled three hikes. In this scenario, however, inflation keeps real interests low. Consequently, this scenario is not a net positive for the dollar.

Their opinion is that even if inflation sets in due to expansionary economic policy the Fed’s higher interest rates will balance off the effects on the dollar.