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#1 30-01-2022 18:28:10

johnedward
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USD: does the dollar gain strength during Fed tightening cycles?

USD: does the dollar gain strength during Fed tightening cycles?


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First, let's cover some basics about the impact of central banks and their interest ratehike and cut process on currencies.

What is a tightening cycle?

A tightening cycle involves a country's central bank raising interest rates.

For example, if it is thought to be good for the economy, the Fed may raise its benchmark interest rate, making saving more attractive than borrowing. The result of this action, all else being equal, would be to strengthen the dollar.

What is an easing cycle?

An easing cycle involves a country's central bank lowering interest rates.

This encourages spending rather than saving by lowering returns on savings accounts or reducing the cost of lending to both consumers and businesses. As a result, the currency loses value as buyers seek higher returns in other currencies.

This also pushes market participants into riskier assets given the low returns on cash.

When do tightening or easing cycles begin?

Historically, easing cycles begin when the economy shows signs of weakness.

This can be reflected in low interest rates, low inflation, low economic growth, high unemployment, among other indicators.

Interest rates are raised when the economy begins to show signs of recovery.

Flexible monetary policy is when central banks begin to reduce interest rates to stimulate economic activity - usually after growth has stopped or is falling and inflation has fallen below its target rate.

Central bankers always aim for an inflation rate of at least zero to avoid deflation and prefer it to be positive but low.

Are tightening cycles bullish for a currency? And why would this be true?

On average, during periods of tightening, the dollar tends to strengthen against foreign currencies when markets begin to discount the fact that the central bank will begin to raise rates more quickly than previously expected.

This happens because international money flows into U.S. investments when domestic interest rates rise, increasing demand for U.S. assets.

In addition, the Fed's large holdings of T-bills tend to strengthen the dollar by raising long-term interest rates when it sells securities to absorb liquidity during or after the start of a tightening cycle.

(However, because of the impact of tightening on inflation - it will lower it, all else being equal - this has the effect of lowering long-term interest rates. Thus, the net impact on bond yields is more nuanced, depending on the competing factors.)

Why do easing cycles weaken a currency?

Typically, international money flows out of U.S. investments and into foreign markets when policies are expected to lead to faster growth or higher inflation rates due to expectations of higher interest rates in other countries relative to the U.S.

This reduces demand for U.S. assets and puts downward pressure on the value of the dollar.

Also, when the Fed buys less securities from banks with all that cash, it reduces the upward pressure on the dollar.

If a central bank is dovish (in favor of a looser policy), how can this be bullish for the U.S. dollar?

A weaker currency can actually make a central bank's interest rate policy more effective.

For example, if the Fed were to lower rates even further from zero (and more negative in real terms from their already very negative levels), it would have been futile because it does little to promote more credit creation.

It also hurts bank profitability in a variety of ways, as banks find it difficult to lend at rates higher than they borrow, part of a process known as disintermediation.

But the Fed can achieve easier policy through quantitative easing/asset purchases or policy coordination with fiscal policymakers to get money and credit to where it is needed.

In this case, the Fed could use a weak currency to fight deflation and provide incentives to buy, borrow and invest.

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