Fed Rate Hike in a Changing World

Economics, Premium POM

Correcting Assumptions on Dollar and Gold Appreciation

By JC Collins

The ongoing crash in the price of gold is symptomatic of a larger process which is taking place in the international monetary system.  The strengthening dollar is now pushing down the price of gold, and the strength of the dollar is being supported by the increasing odds of the first Fed interest rate increase in a decade.

The economics behind these movements are based on simple supply and demand principles.  These assumptions state that when interest rates increase that currency will appreciate.  In this case it is only the anticipation of an interest rate increase that is spurring dollar demand and appreciation.

A stronger dollar is putting downward pressure on commodities, and could even threaten global growth.  This was one of the main reasons that the Fed didn’t raise rates back in September.  But the assumption between interest rate increases and currency appreciation may not be as accurate as initial market reactions would suggest.

Let’s review the fundamentals of this assumption.

First, it is assumed that higher interest rates will attract more foreign capital, as return on investment is increased.  This in turn will increase the demand for domestic capital, which will push up the value of the currency.

Second, it is assumed that higher interest rates will force domestic consumption to decrease.  This reduction in domestic demand will also mean a fall in demand for imports as the people spend less, as they are less inclined to borrow money at higher rates of interests.

As the exchange rate increases, the amount of imports decreases, which continues to feed the reduction of currency, increasing the value.

There is strong evidence to suggest that this argument does not hold weight.

Let’s review the fundamentals of this alternative assumption.

As expected, an interest rate increase will initially correlate to an increase in exchange rate.  We are seeing this today after the US jobs report came out and the odds of a December rate hike by the Fed has jumped to 74%.

But as stated above, higher interest rates will reduce the willingness to borrow and will eventually lead to a reduction in economic activity, such as mortgages, car loans, credit card use, and overall money velocity should temporarily dampen. This reduction will cause a reduction in capital inflows.

After the initial response, the above factors will extrapolate the lower demand for the currency which will cause a depreciation in exchange rate.  A depreciation which the US desperately needs to increase exports and spur domestic production to reduce the debt-to-GDP ratio before the next fiscal budget.

The natural inclination to consider that the USD will continue to appreciate within an economic environment of increasing interest rates is not as supported as we would have thought.  When we add the increasing demand for dollar alternatives, such as the Chinese renminbi, we see that foreign capital will have additional places to move and settle.  As reviewed in the following posts:

US Dollar Will Depreciate by 20% to 30%

And

The Case for Increasing Interest Rates and Depreciating the Dollar

The Internationalization and liberalization of the RMB will offset the USD demand as interest rates increase.  Once the RMB is added to the SDR basket composition, see post Renminbi Demand Is About to Explode, there will be added downward pressure on both the dollar and commodities, including gold.

The only thing that will eventually turn things around for commodities will be the vast funding of massive infrastructure projects in the developing nations.  This funding will come from institutions like the BRICS Development Bank and Asian Infrastructure Development Bank.  See post The Coming Commodities Boom.

As stated above, the initial market reaction is downward pressure on other currencies, such as the renminbi, and commodities, including gold.  This will turn as interest rates incrementally rise throughout 2016 and the renminbi becomes more integrated within the SDR composition.  The increased demand for renminbi will cause a shift in the composition of foreign exchange reserves.

Big adjustments are coming, which include losses in dollar denominated instruments, derivatives, and corporate failures, as interest rates begin their ascent.  This is not the end.  It is another beginning, with much confusion and misinformation in the middle.  – JC