As expected, the U.S. Federal Reserve raised its federal funds target rate by 25 basis points this week to 2 percent. What was less expected was the Fed's announcement that there will be a total of four rate hikes this year, which means that two more are to come in 2018. Previously, it was unclear whether there would be three or four total rate hikes this year.
So how did the U.S. dollar perform given this news? The answer is, it depends.
Against the major currencies, the dollar really did not move that much. However against the emerging market (EM) currencies, the dollar has strengthened, signaling that the higher U.S. interest rates are starting to put some strain on the EM currencies.
EM countries typically run a current account deficit so they rely on foreign capital inflow to fund those deficits. In order to attract that foreign capital inflow, they offer high interest rates. When U.S. interest rates were low, the so-called 'carry trade' (the practice of investors borrowing cheap U.S. capital and investing it in these higher-yielding currencies) supported the EM world.
Last year, the weak dollar also helped those EM economies. But as the interest rate differential between the dollar and emerging market currencies narrows, the latter become less attractive, discouraging investors from taking on the investment risk. With increasing currency volatilities in emerging markets, that is sending capital back into the dollar.
This poses a threat to the EM countries. Their economies grow by leveraging, but not only is that foreign money not coming in, their foreign borrowing levels - primarily denominated in U.S. dollars - are surging as a result of the stronger dollar and higher U.S. interest rates.
To illustrate this phenomenon, since the beginning of this year, the Argentine peso has fallen by about 30 percent, the Turkish lira by 20 percent and the Brazilian real by 11 percent. The South African rand and Russian ruble seem equally vulnerable going ahead.
My View: One currency that has not been affected continues to be the Chinese yuan. With China's GDP now surpassing the U.S. as the No. 1 economic power in the world, it is hard to label China an EM country, but on a per capita GDP basis is still is. Given its ongoing, quasi-fixed exchange rate regime and strong capital controls, however, the Chinese economy has not been affected as much as other EM countries. President Trump said that he will confront China “very strongly" over trade in the coming weeks. While his goal is improving the U.S.-China trade imbalance, if he negotiates on currency policy as well, the other EM countries may not object.
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