Wednesday, June 13, 2018

Braking While Accelerating

Traditionally, increases in interest rates in one country draw money from other countries, seeking the higher rate, which causes the currency of the first country to appreciate and the currency of the second country to depreciate.  For example, to move funds from Japan to the U.S., you have to sell your Yen to buy dollars, which drives up the value of the dollar, because the demand for the dollar increased while the demand for the Yen decreased.  So far this year, interest rates have risen and the dollar has strengthened.  With today's expected increase by the Fed, it is expected the dollar will continue to strengthen.

But, to an unusual extent, currencies are reacting less to interest rates and more to political expectations.  When Italy spooked the market recently, there was no change in interest rates by the ECB.  Yet, the euro took a beating.  The increase in interest rates in the U.S. is too small to explain the big rise of the dollar.  Geopolitical enthusiasm for the Trump Tax Cuts (AKA the Trump Fiscal Stimulus) increased demand for dollars to buy equities more than the increase in demand to buy bonds.  That geopolitical enthusiasm was rocket-fuel to the dollar already propelling upwards by interest rates.

It is not happened in U.S. history before, that we have the Fed applying monetary brakes, while the central government is hitting the accelerator with a stimulus plan. In the short run, it doesn't matter but could be important in the long run.  That means, in the short run, the dollar will remain strong, but, in the long run, who knows?