How will FED’s monetary tightening affect the USD?

The dollar has soared over the last six months as the Fed has hiked rates

>> The reasons for the USD dollar’s rise

Are Fed rate hikes associated with a rising dollar and Fed cuts conducive to dollar weakness? It sometimes seems that the market sees it this way. The dollar has soared over the last six months as the Fed has hiked rates, and if you listen to most commentators, it seems that they think that the dollar will only start coming down when the Fed at least pauses rate hikes, if not cuts them altogether. But it is not as simple as this at all. Context is crucial. It explains why, for instance, the dollar is just as likely to fall as US rates rise and why, most often, the biggest increases in the dollar occur when the Fed is slashing rates.

For many investors, any Fed tightening is bad news as it might be expected to lower asset values. But when it comes to the dollar, there can be Fed tightening that is good for the dollar and tightening that is bad for the dollar. The former occurs when inflation is low but the economy is strong and the Fed is tightening to head off any threat of future inflation. Bad tightening occurs when the economy is weak but inflation is high and the Fed is running to keep up with rate hikes. Quite clearly, what we are seeing today is "bad" tightening because the economy is weak, inflation is high, and the Fed has been late to the game.

As a result, its rate hikes have unsettled financial assets, with both bonds and stocks falling. Contrast this with the last tightening cycle between 2015 and 2018. Not only did the Fed lift rates 225 basis points in this cycle, but virtually no other major central banks lifted their own rates—unlike today.

During this period, the US economy was reasonably robust, inflation was contained, and the Fed hiked to prevent future inflation. As a consequence, it was a generally good period for asset prices, and the result was that the dollar was lower at the end of the Fed’s tightening cycle than it was at the start. So, this was a case of "good" tightening; something that lifted the global investor mood, and weighed on the dollar.

From all this, we can see a pattern that it is not really whether US rates are going up or not, but whether they are doing so in the context of rising or falling asset prices. In other words, it is asset prices rather than interest rates that are important to the dollar.The reason for this relates to something we have talked about recently, which is the hedging of asset purchases through FX and currency swaps.

Mr. Steve Barrow, Head of Standard Bank G10 Strategy said that when asset prices are tumbling, during a period of "bad" Fed tightening, investors tend to find that they have over-hedged; their asset position; they are too short of the dollar. In buying these back through the spot market, the dollar rallies. And this rally can be especially dramatic when the world is in a financial crisis, because the rush for dollars is intense, and it can even continue if the Fed is cutting rates.

>> Eyeing a turnaround in the greenback

In contrast, "good" tightening from the Fed that lifts investors’ mood and lifts asset prices leaves them underhedged as the value of their assets rises, leaving them with excess dollars that can then be sold out in the spot market, which, in turn, depresses the dollar.

"Now we dare say that there’s all sorts of other activity in the spot market through these periods having to do with carry trades, safe-asset demand, speculation, and more. But our sense is that these swap-related flows are pretty dominant. That’s not surprising given that the BIS calculated not too long ago that the amount of dollar borrowing financed through FX derivatives in off-balance sheet transactions is at least as large as on-balance sheet borrowing via bonds and bank loans, etc", said Mr. Steve Barrow.

It is probably an area overlooked by analysts as it is easier to focus on what’s more observable, like rate changes themselves, economic data, and all the rest. But this misses the point. It is a bit like the old joke about the man wandering down a darkened street when he sees another man searching beneath a streetlamp. He asks what the man is looking for, and the reply is that he has lost his car keys. "Did you lose them under this streetlight?" he asks, to which he was told, "no, but it is much easier to look for them under here".