On September 18, the Federal Reserve began its highly anticipated easing cycle with a 50 basis point cut, bringing the fed funds rate to 4.875%. This aggressive move has significant implications for the domestic economy, as lower borrowing costs are expected to boost demand for assets and encourage business expansion and consumption.
However, the move is atypical in that the chairman Jerome Powell has clarified that the goal is not necessarily to boost demand. The Fed believes that the fight against inflation is not entirely over, and the rate reduction is intended to maintain restrictive monetary policy, albeit less restrictive than before. The economy appears to remain relatively strong, and the policies’ stated aim is to move toward a neutral rate that's neither accommodative nor restrictive, which the chairman believes is well below current levels.
U.S. Rates Stir Global Currencies
Beyond domestic implications, U.S. rate policy has substantial effects on global economies and currencies. While lowering interest rates generally weakens a nation's currency, the specific reactions can vary among different currencies.
Euro: As the world's second most traded currency, the euro would be expected to rise against the dollar in proportion to the rate differential between the countries. This is primarily due to global capital flows. When U.S. rates are relatively high, global capital tends to flow into dollar-denominated assets. Conversely, when U.S. rates fall, there's an incentive to sell dollars and invest in higher-yielding currencies.
Yen and Swiss Franc: Historically viewed as "safe haven" currencies, the yen and Swiss franc tend to benefit during times of economic distress. If markets perceive the Fed rate cut as globally stimulative, these currencies might be sold as investors seek higher-risk assets. However, if the market interprets the Fed's action as a response to an impending economic downturn, these currencies could benefit from their safe-haven status.
Investors can employ various strategies to hedge against a potential long and deep rate cut cycle. If an investor believes the dollar will weaken, they could buy futures in currencies expected to strengthen, such as the yen. Japanese yen futures are seeing increased interest, with average daily volume increasing 23% to 216,000 contracts in Q3 2024 compared to Q3 2023.
It's worth noting, however, that rates aren’t the only factor to consider. The yen's position may also be impacted by recent economic events, such as Japan’s move out of negative rates this year, and its significant depreciation against the dollar over the last five years.
Australian and Canadian Dollars: These "commodity currencies" tend to correlate with specific commodity prices. The Canadian dollar is closely linked to crude oil prices due to Canada's export relationship with the U.S. The Australian dollar is more closely tied to gold prices because of its large mining sector. If rate cuts in the U.S. are expected to increase demand for commodities, these currencies would likely outperform.
Emerging Markets: Perhaps the largest potential impact of U.S. rate policies is in emerging market economies. The current weaker dollar policies may benefit these markets in several ways:
- Capital outflows from the U.S.: As U.S. investments become less attractive, riskier investments in emerging economies tend to become more appealing.
- Debt servicing: Many emerging market countries and companies have dollar-denominated debt. A weaker dollar makes it easier to service this debt.
- Monetary policy space: Lower U.S. rates allow emerging economies more freedom to adjust their own rates without fear of significant capital flight.
A Global Impact
The Federal Reserve's rate decisions have far-reaching consequences that extend beyond the U.S. economy. They influence global capital flows, currency valuations, and economic conditions in both developed and emerging markets. As the Fed navigates the delicate balance between supporting economic growth and managing inflation, market participants must remain aware of potential risks or opportunities of the changing landscape.
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