FED's Interest rate hike and the USD

March 14, 2014 by Matt McCracken

The popular view is higher interest rates should be supportive of the underlying currency.  The idea is simply that a higher yielding currency is more attractive to investors.  And given that the USD is the only major currency yielding anything, the USD should be pretty attractive right now.  

But there maybe a problem with this line of thinking.  The problem is the owners of US Treasury debt dwarfs the potential buyers of US Treasury debt.   And the owners of the debt just saw that huge pile of debt discounted.  As rates rise, the price of the underlying debt must be discounted to offset for the new higher rates.  So will the holders of US Treasury debt start selling and will this selling overpower the buyers?  If so, the USD will actually weaken versus strengthen.   And strength of the USD has been the cornerstone of all the FED's power to "support" equity and debt markets.   

The initial response to the interest rate hike by the FED led to weakness in other competing currencies.  And the verdict will be out for the next few days.  But as I bang out this post on my keyboard, the Euro and other major currencies have recovered all their post announcement losses.  If the USD weakens over the next several days, watch for continued weakness in all USD denominated assets.