Thursday, 28 September 2017

Rate Hikes And The Dollar: A Relation To Watch

Posted by Valentine at 10:42 Labels:

The Federal Reserve is moving forward with its monetary policy normalization process. And interest rate hikes are not the only method in play, the regulator is also unwinding its massive $4.5 trillion balance sheet starting from October.

Federal Reserve Chairwoman Janet Yellen hinted on a third rate hike later this year, explaining that slowing down monetary adjustments could be dangerous for the economy.

“We should also be wary of moving too gradually,” Yellen said on Tuesday before the National Association for Business Economics annual meeting in Cleveland.

The Fed’s chief reassured that inflation continues to be a key benchmark for the central bank, but pointed out that interest rate hikes cannot be entirely tied to inflation performance and whether it will reach or not the regulator’s 2 percent target.

The hawkish rhetoric has not only been embraced by Yellen. Twelve members of the Federal Open Market Committee are currently expecting further monetary changes before New Year.

According to Fed funds tracked by CME Group’s FedWatch program, the probability for a 25 basis points rate increase by December currently stands at 76.4 percent. Fed’s short term interest rate is now placed in a range between 1.00 percent and 1.25 percent.

But raising interest rates is not enough. The $4.5 trillion issue was meant to be addressed later or sooner and in the latest monetary policy meeting, policymakers agreed on a plan to unwind the balance sheet in a gradual way (of course).

But first… what does “unwind” really means? Don’t worry. You are not the first to wonder about this term. In simple words, it means reducing Fed’s bonds steak by selling them or in an even clearer way, turning them into cash or monetizing debt.

The Federal Reserve will start “small” by allowing $10 billion per month, of which $6 billion will be Treasury securities and $4 billion will be mortgage-backed securities. As the plan evolves, the idea is raise that $6bn / $4bn cap to $30bn / $20bn.

And so… the big question for investors is how these two monetary policy adjustments will play out for US dollar? Let’s take a minute to think about it.

If the Federal Reserve increases interest rates while other regulators around the world keep or reduce their benchmark rates (Bank of Japan, ECB…), then the saving payouts in the US will be more attractive than in other places. Following with this example, investors are likely to move their capital to the US, resulting in the dollar’s strengthening.

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