A trend is a pattern that continues to perpetuate. Generally, investors look at an uptrend or a down trend in the price of an asset as continuous. The trend that has perpetuated for most of 2019, is the uncertainty related to the Trump Administration and the rising dollar. While the trend in the dollar index has been choppy, the rise in US interest rates relative to its counterparts has helped buoy dollar trading to multi-year highs.
What is Driving the Rise in the Dollar?
The rise in the US dollar has been perpetuated by a rise in US interest rates relative to its counterparts. This is called the interest rate differential. The interest rate differential is defined as the difference between two countries short-term interest rates. During the past 4-month US short term rates have increased relative to Euroibor which are European short term rates. Currently, the differential is 2.8%, which means that if the investor buys the dollar and hold it for a year against the Euro, for an entire year, it will earn 2.8%.
How Do Interest Rates Effect Currency Rates?
Interest rates are an integral part of the currency markets. Interest rates make up the forward curve, which is a portion of the rate that investors buy and sell if they plan to hold their currency position for longer than 2-business days. The spot rate, which is settled in 2-business days, is altered with forward-points making up the forward rate if the individual holds their positions beyond 2-business days.
What Drives Interest Rates?
Short-term interest rates are driven by future changes in monetary policy. Strong growth and rising inflation are generally the two components that alter the landscape of monetary policy. In the US there has been strong-growth and inflation which has reached the upper end of the Federal Reserves target range. In Europe and Japan, growth has been slow and inflation is well below the European Central bank and the Bank of Japan’s target range. This has led to a rise in US rates, which last raised interest rates in December and a decline in both European and Japanese interest rates.
Will the Trend Continue?
It appears that while US interest rates might have peaked in the short-term, European rates are beginning to slide. This is because both growth and inflation in Europe is declining, which might keep the interest rate differential trending in favor of the US dollar. Inflation in the US has started to top out, but growth and strong jobs data continue to show strength. The most likely scenario is that the dollar continues to trend higher as US interest rates edge higher versus both Euribor and Japanese interest rates. The uncertainty related to the Trump administration has also helped buoy the US dollar. The dollar is also viewed as the safe-haven currency and as geopolitical events occur, the dollar becomes stronger.
