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Monday, 30 January 2023
USD climbs to near 20-year peak vs yen as more Fed hikes loom

USD climbs to near 20-year peak vs yen as more Fed hikes loom

2022-10-31

The dollar has climbed to its highest levels in more than a decade against a number of currencies, while crude oil falls to its lowest level in nearly a year. The surge in the greenback comes at a time when the Federal Reserve is readying to begin its fourth round of interest rate hikes this year. The recent run-up in the dollar has also been a major worry for exporters, but the recent weakness in global equity markets means the buying opportunity for dollar-based foreign exchange traders has only widened. The dollar has risen to a near-20-year peak versus the yen as the US Federal Reserve prepares to embark on its next round of tightening. That’s mainly because of the dollar’s increased role as a reserve currency. The rise of the greenback comes as the increasing likelihood of renewed interest-rate hikes in the US Federal Reserve. The current rate hike cycle is the first to start with a new chairman, Jerome Powell, in place. Many analysts expect the Fed to raise its target for the federal funds rate by a total of four times this year. That would push the Fed Funds Rate to between a meagre 1% and a stunning 3% by the time it is finished. “The prospect of a fourth rate hike in as many months and the first with a new chairman Jerome Powell suggests the Fed considers the path of monetary tightening already underway to be unravelling,” says Chris Weston, FX and commodities strategist at Standard Life Investments.

What does the Fed do with rate hikes?
Since the Great Depression, the Federal Reserve has raised the federal funds rate several times. In each case, it saw the Fed Funds Rate rise as high as 14% before falling back to around 6.5% over the next two years. That rate rise, coupled with a cut in the money supply to support economic growth, helped the Fed Finland achieve real wage growth and relatively strong growth in the American economy. The Fed Funds Rate in the United States is the main factor that determines interest rates in foreign countries. The impact of the Fed hiking rates on the value of the dollar and interest rates in the rest of the world depends on how quickly the Fed hikes rates. If the Fed goes into reverse and halts its rate hikes, the dollar will weaken and interest rates in the rest of world will also rise. That will have a knock-on effect on the value of the dollar, causing interest rates in the US to fall and increasing the country’s economic output and employment. The Federal Reserve Funds Rate is not expected to rise much above 6.5% until the second half of 2019 at the earliest.

The potential impact of a ‘death spiral’
There is a major risk that the Fed Funds Rate will rise too high and cause a further financial crisis. This can happen when the central bank starts to increase rates and suddenly the entire financial system is exposed to higher interest rates. In the worst-case scenario, a “death spiral” could unfold. This is a term applied to share markets that tank as people lose confidence in the banks and the economy as a whole. This could happen if interest rates in the US exceed 8% and the government then raises taxes to pay for the higher interest rates. Such a scenario would have a huge knock-on effect on the rest of the world, with share prices of banks and other financial institutions in many countries falling, and the economy and jobs being threatened.

The risk of a ‘froth’ in emerging markets
The recent rise in the value of the dollar has been a major worry for many emerging market economies. Meanwhile, the market expectation is that the Federal Reserve will start to raise interest rates in the US this year. There are fears that this could spark a “froth” in some countries, such as in India where the rupee has already depreciated by over 40% against the dollar over the last year. Other emerging market economies, such as Brazil and Russia, are also vulnerable to a dollar-based financial crises. The risk for emerging market economies is that sudden and strong dollar strength could provide a spark for financial instability, triggering a major currency crisis. Such a scenario could see the dollar falling against major currencies, with a knock-on effect on the rest of the world.

The real risk of more dollar strength
The recent run-up in the dollar has also been a major worry for exporters, but the recent weakness in global equity markets means the buying opportunity for dollar-based foreign exchange traders has only widened. If US interest rates start to rise, it would be a major positive for exporters. However, the risk of another major economic downturn in the US, coupled with rising interest rates there, could spark a financial crisis and further depreciation of the dollar.

More dovishness from the BOJ
The BOJ has also been relatively dovish recently. In June it unexpectedly raised its key interest rate by a quarter of a percentage point to a record low 1.75%. The BOJ also surprised markets by lowering its bond yield target by the same amount. The BOJ is widely seen as the main bulwark against deeper central bank cuts in the event of a financial crisis. The BOJ has been lowering its key interest rate since October 2013 and also miscalculated its bond yield target. In the event of a financial crisis, the central bank is required to take stringent monetary and economic measures to quell inflation and protect the economy. The euro and the single currency risk
The recent dollar surge is also a major risk to the euro. The euro has been strengthening against the dollar since the start of the year and is now the most valued currency in terms of the dollar. A strong dollar combined with a rising euro makes exports more expensive in both countries and has the potential to spark a trade war. The European Central Bank (ECB) has been hiking rates to prepare for more interest rate rises, but the rise of the dollar could complicate its plans and send the euro lower. If a trade war breaks out, that could further weaken the dollar and hurt exporters. The ECB is expected to increase interest rates again in January, but the effect of the rise in the dollar on the euro is unclear. Continuity in emerging market central banks
The dollar surge has also been a major worry for central bankers and financial regulators. The Bank of Japan (BOJ) and the People’s Bank of China have both been buying massive amounts of assets to support the currencies of struggling countries. The fear is that these central banks could try to use the plunge in the dollar as an excuse to slow down or cut back on their efforts to prop up the currencies. That would damage confidence in the dollar and the economy in general. Meanwhile, the People’s Bank of China has bought US government bonds to prop up the value of the yuan and is expected to buy more financial assets in the coming months. Japan and the yen: The classic case against strength
The dollar and the euro have also been major concerns for investors in Japan. The yen has been strengthening against the dollar since the start of the year and is now the strongest currency in the world. The Japanese central bank has been buying government bonds to prop up the yen and is expected to buy more financial assets in the coming months. That could hurt emerging market and other companies based in China and India. The Japanese economy is huge, with a population of over 130 million people. The country is a major manufacturing and trading power, with a wide range of industries and a large population of working age people. Conclusion – Is the dollar about to fall?
The recent appreciation of the dollar has been a major worry for investors, but the fact that the dollar is also a reserve currency means it has relatively little downside risk. That said, there is a real risk of a “death spiral” in some emerging market economies if interest rates rise too quickly and allow debt to rise. That could lead to social unrest and a drop in economic growth. If the dollar falls, that could have a large knock-on effect on the world economy, with shares in small and medium-sized companies falling and inflation rising. If the dollar falls too low, that would be a major disaster for the world economy and financial system.

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