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Why the Fed’s Interest Rate Cut Could Weaken the US Dollar
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Here’s the basic idea: An environment of rising U.S. interest rates relative to those elsewhere is generally “dollar-positive,” said Jonathan Petersen, senior markets economist and currency expert at Capital Economics.
In other words, rising rates support a stronger U.S. dollar against foreign currencies. Americans can buy more things with their money abroad.
The opposite dynamic — falling interest rates — tends to be “dollar negative,” Petersen said. A weaker dollar means Americans can buy less abroad.
Fed officials signaled in June that expects to cut rates once in 2024 and four additional times in 2025.
“Our expectation now is that the dollar will come under more pressure next year,” Petersen said.
However, this is not necessarily a foregone conclusion. Some financial experts believe the dollar’s strength may have staying power.
“There have been some headlines calling for the end of the US dollar,” said Richard Madigan, chief investment officer at JP Morgan Private Bank. he wrote in a recent note. “I continue to believe that the dollar remains the one-eyed man in the land of the blind.”
The Federal Police started to get up interest rates aggressively in March 2022 to tame high pandemic-era inflation. By July 2023, the central bank had raised rates to highest level in 23 years.
The dollar’s strength increased in this scenario.
O Broad Nominal US Dollar Index is higher than at any pre-pandemic point dating back to at least 2006, when the central bank began tracking such data. The index measures the dollar’s appreciation against the currencies of the country’s major trading partners, such as the eurothe Canadian dollar and the Japanese yen.
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For example, in July 2022, the US dollar reached parity with the euro for the first time in 20 years, meaning they had a 1:1 exchange rate. (The euro has recovered somewhat since then.)
In early July, the US dollar reached its strongest level against the yen in 38 years.
A strong U.S. dollar gives you “a discount on everything you buy while you’re abroad,” Petersen said.
“In some ways, it’s never been cheaper to go to Japan,” he added.
A record number of Americans visited Japan in April, according to the Asian country’s tourism board. Benjamin Atwater, communications specialist at InsideAsia Tours, a travel agency, attributes this in part to Financial incentive granted by a strong dollar.
In fact, he personally recently extended a work trip to Japan by a week and a half — rather than opting to travel elsewhere in Asia — largely because of the favorable exchange rate.
Everything from meals, hotels, souvenirs and car rentals were “a great value,” said Atwater, who lives in Denver and has long wanted to travel to Japan.
“It has always been portrayed as one of the most expensive places to visit, [but] “I was getting some of the best steaks I’ve ever had for about $12,” he said.
In reality, the dynamics that drive dollar fluctuations are more complex than whether the Fed raises or lowers interest rates.
The differential in U.S. rates relative to other nations is what’s significant, economists said. Fed policy doesn’t exist in a vacuum: Other central banks are also simultaneously making interest rate choices.
The European Central Bank cut interest rates in June, for example. Meanwhile, the Fed kept rates higher for longer than many analysts had predicted — meaning the rate differential between the U.S. and Europe has widened, helping to support the dollar.
“The Fed is on hold, other central banks are preparing to ease and the Bank of Japan (BoJ) seems stuck in a moment,” wrote JP Morgan’s Madigan.
U.S. Federal Reserve Chairman Jerome Powell speaks during a Senate Banking, Housing and Urban Affairs Committee hearing on July 9, 2024.
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“If Japan wants the yen to stabilize, interest rates need to rise,” he added. “That doesn’t look like it will happen any time soon. With the ECB expected to cut before the Fed, I expect the current weakness in the euro to prevail as well.”
This is happening in the context of a relatively strong U.S. economy, which also generally supports a strong dollar, Petersen said. At a high level, a strong economy generally means there will be higher economic growth and/or inflation, which means a higher likelihood that the Fed will keep interest rates relatively high, he said.
A strong economy also tends to encourage foreigners to deposit more money in the U.S., he said.
For example, investors generally get a better return on their money when interest rates are high. If an investor in Europe or Asia were getting maybe 1% or 2% on bank account holdings while such holdings in the U.S. were yielding 5%that investor may transfer some money to the U.S., Petersen said.
Or an investor might want to hold a larger portion of his portfolio in U.S. stocks rather than European stocks if the outlook for economic growth is not good in Europe, he said.
In such cases, foreigners buy dollar-denominated financial assets. They would sell their local currency and buy the dollar, a process that ultimately increases the dollar’s strength, Petersen said.
Exchange rates “depend on capital flows,” he said.
While these dynamics are also true in emerging markets, currency fluctuations can be more volatile than in developed countries due to factors such as political shocks and risks to commodity prices such as oil, he added.