For those who like to dabble in currency trading — and there’s more than a few of you — the chart below may be of interest.
From Nomura, it shows the reaction in the US dollar index, or DXY, before and after interest rate increases from the US Federal Reserve over the past few years.
Nomura/Bloomberg
While the performance of the dollar before rate hikes has had mixed fortunes, the same can’t be said after the Fed actually lifts rates.
On most occasions, the dollar actually falls, rather than gains, following a rate hike.
So what gives? Aren’t higher interest rates supposed to make a currency more attractive to investors, seeing its value increase?
In theory, yes. But the dollar’s movements aren’t being driven by actual rate increases, but rather expectations of what may happen in the future.
The pattern was yet again seen following the last interest rate increase from the Fed back in December last year, as Bilal Hafeez, strategist at Nomura, explains.
“Markets are all about expectations and it was likely the expectation of the December Fed hike that was helping the dollar,” Hafeez says.
“The actual hike, then, would naturally reset those expectations and would lead to a ‘buy the rumour, sell the fact’ dynamic in the dollar. Indeed, the dollar has followed a pattern of trading relatively well into Fed hikes, but selling off after.”
Essentially, the Fed — like other major central banks in recent years — has become so good at priming markets to expect a change in policy that by the time the change is actually delivered it’s close to fully priced.
With markets expecting a hike, they naturally position for it as well, creating a scenario where rather than buying on the actual increase they take profit on prior gains, selling the dollar instead.
It’s happened time and again, as seen in the chart.
Another consideration is every rate increase brings the Fed closer to finishing its tightening cycle, coming at a time when other major central banks are either starting to, or about to start, lifting interest rates.
For a market that is more interested in what will happen in the future rather than today, it helps explain why so many currencies gained against the dollar last year despite the Fed being one of the few major central banks who were actually lifting interest rates.
Given that markets are already expecting US interest rates to rise two or three times this year, according to most economists, that means those expected changes are largely factored in by financial markets.
Something to consider, especially given the dollar’s recent track record following rate hikes.
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