Why the Fed's Rate Cut Could Weaken the US Dollar

SeongJoon Cho/Bloomberg via Getty Images

The U.S. Federal Reserve could cut interest rates before the end of the year, which could make future trips abroad more expensive for travelers in the country.

This is due to the way interest rate policy affects the strength of the US dollar.

The basic idea is this: An environment of rising US interest rates relative to other countries is generally “dollar positive,” according to Jonathan Petersen, senior market economist and currency specialist at Capital Economics.

In other words, rising rates support a stronger U.S. dollar against foreign currencies. Americans can buy more stuff with their money abroad.

The opposite dynamic — falling interest rates — is typically “dollar negative,” Petersen said. A weaker dollar means Americans can buy less abroad.

Goldman Sachs' Jan Hatzius says Fed 'most likely' to cut rates in September

Fed officials indicated in June that they expect to cut rates once in 2024 and then four more times in 2025.

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

That's not necessarily a foregone conclusion, though. Some financial experts think the dollar's strength could be here to stay.

“There have been quite a few headlines calling for the demise of the US 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.”

Why the US Dollar Is at a 'Discount' Abroad

The Fed began aggressively raising interest rates in March 2022 to curb high pandemic-era inflation. By July 2023, the central bank had raised rates to their top level in 23 years.

Against this backdrop, the dollar continued to strengthen.

The Nominal broad US dollar index is higher than at any pre-pandemic point dating back to at least 2006, when the central bank began tracking such data. The index measures the dollar’s ​​appreciation against currencies of the country’s major trading partners, such as the euro, Canadian dollar and Japanese yen.

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For example, in July 2022, the US dollar reached parity with the euro for the first time in 20 years, meaning the exchange rate was 1:1. (The euro has since appreciated somewhat.)

In early July, the US dollar reached its strongest level against the yen in 38 years.

A strong US dollar gives “a discount on everything you buy when you're abroad,” Petersen said.

“In some ways, it's never been cheaper to go to Japan,” he added.

A record number of Americans visited Japan in April, according to the Asian country’s tourism board. Benjamin Atwater, a communications specialist at InsideAsia Tours, a travel agency, attributes that in part to the financial incentive provided by a strong dollar.

He recently personally extended a work trip to Japan by a week and a half, instead of traveling elsewhere in Asia, mainly because of the favorable exchange rate.

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

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

How Interest Rates Affect the US Dollar

In reality, the dynamics driving dollar movements are more complex than whether the Fed raises or lowers rates.

The difference in U.S. interest rates relative to other countries is what matters, economists said. The Fed's policy doesn't exist in a vacuum: Other central banks are making rate decisions at the same time.

The European Central Bank For example, cut rates in June. Meanwhile, the Fed has kept rates high longer than many analysts expected — meaning the interest rate differential between the U.S. and Europe has widened, supporting the dollar.

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

U.S. Federal Reserve Chairman Jerome Powell speaks during a hearing of the Senate Committee on Banking, Housing and Urban Affairs on July 9, 2024.

Bonnie Cash | Getty Images News | Getty Images

“If Japan wants the yen to stabilize, policy rates need to go up,” he added. “That doesn't look likely to happen anytime soon. With the ECB expected to catch up with the Fed, I expect the current weakness in the euro to persist as well.”

This is happening against the backdrop of a relatively strong U.S. economy, which generally also supports a strong dollar, Petersen said. At high levels, a strong economy means there will generally be higher economic growth and/or inflation, which means the Fed is more likely to keep interest rates relatively high, he said.

A strong economy also typically encourages foreigners to park more money in the U.S., he said.

For example, investors generally get a better return on money when interest rates are high. If an investor in Europe or Asia might get 1% or 2% on bank accounts while those investments in the U.S. were yielding 5%, that investor might move some money to the U.S., Petersen said.

Or an investor might choose to allocate a larger portion of his portfolio to U.S. stocks rather than European stocks if economic growth prospects in Europe are not good, he said.

In such cases, foreigners buy financial assets denominated in dollars. They sell their local currency and buy the dollar, a process that ultimately boosts the dollar's strength, Petersen said.

Exchange rates “are all dependent on capital flows,” he said.

While these dynamics also apply to emerging markets, currency movements there can be more volatile than in developed countries, due to factors such as political shocks and risks to commodity prices, such as oil, he added.

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