Why a Fed rate cut could weaken the US dollar

The US Federal Reserve could begin cutting rates of interest before the tip of the yr. This could make future foreign travel dearer for US travelers.

The reason for that is the impact of rate of interest policy on the strength of the US dollar.

The basic idea is that this: An environment of rising U.S. rates of interest relative to those of other countries is mostly “dollar positive,” says Jonathan Petersen, senior market economist and foreign exchange specialist at Capital Economics.

In other words, rising rates of interest make the U.S. dollar stronger against foreign exchange. Americans should purchase more things with their money abroad.

The opposite dynamic – falling rates of interest – tends to be “dollar negative,” says Petersen. A weaker dollar implies that Americans should purchase less abroad.

In June, Fed officials indicated that they expect one rate cut in 2024 and 4 more cuts in 2025.

“We currently expect the dollar to come under greater pressure next year,” Petersen said.

However, this shouldn’t be a foregone conclusion. Some financial experts imagine that the dollar's strength might be here to remain.

“There have been numerous headlines predicting the demise of the U.S. dollar,” said Richard Madigan, chief investment officer at JP Morgan Private Bank. wrote in a recent note. “I continue to believe that the dollar remains the one-eyed man in the land of the blind.”

The Fed began aggressively raising rates of interest in March 2022 to curb high inflation through the pandemic. By July 2023, the central bank had raised rates of interest on its highest level in 23 years.

Against this background, the strength of the dollar increased sharply.

The Nominally broad US dollar index is higher than at any time before the pandemic since not less than 2006, when the central bank began collecting such data. The index measures the appreciation of the dollar against the currencies of the country's major trading partners, akin to the euro, Canadian dollar and Japanese yen.

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For example, in July 2022, the U.S. dollar reached parity with the euro for the primary time in 20 years, meaning they’d a 1:1 exchange rate. (The euro has since recovered somewhat.)

At the start of July, the US dollar reached its strongest level against the yen in 38 years.

A powerful U.S. dollar results in “a discount on any purchases you make abroad,” Petersen said.

“In some ways, it has never been cheaper to travel to Japan,” he added.

A record variety of Americans visited Japan in April, in response to the Asian country's tourism office. Benjamin Atwater, communications specialist at travel agency InsideAsia Tours, attributes this partly to the financial incentive offered by the strong dollar.

In fact, he personally recently prolonged a business trip to Japan by per week and a half – reasonably than choosing a visit to a different a part of Asia – mainly due to the more favorable exchange rate.

Everything from the meals to the hotels and souvenirs to the rental automobile was “a great value,” said Atwater, who lives in Denver and has long desired to travel to Japan.

“It was always portrayed as one of the most expensive places to go, [but] For about $12, I got some of the best steaks I've ever eaten,” he said.

In reality, the dynamics that cause dollar fluctuations are more complex than whether the Fed will raise or cut interest rates.

The difference between US interest rates and those of other countries is crucial, economists said. The Fed's policy does not exist in a vacuum: other central banks are also making interest rate decisions at the same time.

For example, the European Central Bank cut interest rates in June. At the same time, the Fed kept interest rates high for longer than many forecasters had expected. This means that the interest rate differential between the US and Europe has widened, which is benefiting the dollar.

“The Fed is waiting, other central banks are preparing to ease monetary policy, and the Bank of Japan (BoJ) appears to be at an impasse,” wrote JP Morgan's Madigan.

“If Japan wants the yen to stabilize, it will have to raise interest rates,” he added. “But that doesn't seem likely to happen any time soon. With the ECB expected to cut rates before the Fed, I expect the euro's current weakness to continue.”

This is happening against the backdrop of a relatively strong U.S. economy, which generally supports a strong dollar, Petersen said. At high levels, a strong economy generally means higher economic growth and/or higher inflation, which in turn means a greater likelihood that the Fed will keep interest rates relatively high, he said.

A strong economy also usually provides an incentive for foreigners to park more money in the United States, he said.

For example, when interest rates are high, investors generally get a better return on cash. If an investor in Europe or Asia was getting perhaps 1 or 2 percent return on bank deposits, while such deposits in the U.S. were yielding 5 percent, that investor might move some of his money to the U.S., Petersen says.

Or an investor may want to invest a larger portion of his portfolio in U.S. stocks rather than European stocks if the economic outlook in Europe is not good, he said.

In such cases, foreigners buy dollar-denominated financial assets. They sell their local currency and buy dollars, which ultimately increases the strength of the dollar, says Petersen.

Exchange rates are ultimately about “capital flows,” he said.

While this dynamic also applies to emerging markets, currency fluctuations there might be more volatile than in developed markets as a consequence of aspects akin to political shocks and risks to commodity prices, akin to oil, he added.