Higher US Rates, Stronger Dollar Look Again

Eran Peleg, CIO October 3, 2018

Currencies typically strengthen as interest rates go up. Higher rates/yields on offer draw more investors to the currency, pushing up its value.

The US Federal Reserve has been on a rate-hiking campaign since December 2015. 2-year US Treasury yields are now above 2.8%. At the same time, interest rates and bond yields in most other developed countries have remained very low, if not outright negative. For example, 2-year German government bonds are currently yielding (-0.5%). The yield differential is the widest it has been for decades.

US Dollar (Trade-Weighted) Index:

The US dollar is up this year: it has strengthened by around 3% on a trade-weighted basis. However -- Surprise! -- when examining the dollar’s performance since the Fed started raising rates on December 16th, 2015, one discovers that over the entire period, the American currency has not strengthened at all. In fact, it is slightly down (by 2-3%) on a trade-weighted basis. The dollar did have a big up-move in recent years – however, it occurred in 2014 and in Q1 2015, before US rates started to rise. Since then, the dollar has generally been going sideways, within a wide range – see chart.

It is a puzzle why the dollar has not strengthened. There are several possible explanations for the phenomenon, including (1) the US interest rate move was priced into the currency well in advance, in 2014, (2) growth expectations for developed countries outside the US (e.g. Europe) increased more than for the US in recent years, and (3) the process of quantitative easing/tightening is confusing the situation. However, no explanation is satisfactory. For whatever reason, the typical relationship between interest rates and currency has broken down here.

Niels Bohr, the Danish Physicist, famously said: “Prediction is very difficult, especially if it’s about the future”. Sensible investors know that they can’t predict the future. What they can do is assess the risk/reward of any investment (or asset-class) based on a map of probable scenarios and their associated probabilities. Having said that, experienced investors know that currencies have always been notoriously difficult to deal with, more than equities and interest rates. It seems like it just got even more challenging.