The U.S. Dollar is Rising, Interest Rates Could Be Next

Since bottoming July 1, the U.S. dollar1 has mounted an impressive rally against virtually every major foreign currency. While many analysts have been predicting a secular appreciation in the U.S. dollar on account of stronger economic fundamentals, the current rally has caused even casual market participants to take notice. While the dollar is currently up over 5% from its lows, we believe that this move could persist as the outlook for Federal Reserve (Fed) tightening becomes more apparent.2 However, could the rise of the U.S. dollar be interpreted as a signal from the market that tightening could be coming sooner than fixed income markets currently expect?

A difficulty that many investors may have experienced in positioning their portfolios for the prospect of rising rates in the U.S. is that this shift requires not only a positioning element but a timing element as well. Given that hedging incurs costs, investors may prefer to delay moving to more defensive strategies until they have greater conviction about a move in rates. In our view, the most recent interest in the U.S. dollar could be an indication that Fed tightening could occur sooner than interest rate futures currently forecast.

Over the course of the current rally, the U.S. dollar has continued to advance against nearly every major developed market currency and some emerging market currencies as well. International finance teaches us that relative interest rates can have a significant impact on a currency’s exchange rate. As we noted previously, as interest rates rise compared with those in foreign markets, currencies tend to strengthen; when interest rates fall, the currency tends to depreciate as investors hunt for carry. While a decent portion of the recent strength in the dollar has been caused by foreign rates falling on the back of central bank stimulus, we believe that it may be only a matter of time before short-term rate markets begin to price in impending changes in Fed policy. In our view, the recent move in the dollar could indicate changes to come.
Bloomberg Dollar Spot Index, 12/18/13-9/18/14

While currency fluctuations can most easily be observed as part of an investor’s international equity allocations, we have long advocated taking a proactive approach to currency investing as a distinct asset class from stocks and bonds. In addition to differences in economic fundamentals in the current market environment, the U.S. dollar has a long history as a potential safe haven asset during times of market uncertainty. With geopolitical risk and economic uncertainty persisting in Europe, we believe the dollar to be a natural beneficiary, regardless of changes in central bank policy. 
1As proxied by the Bloomberg Dollar Spot Index
2Source: Bloomberg, as of 9/18/14.

Important Risks Related to this Article

There are risks associated with investing, including possible loss of principal. Foreign investing involves special risks, such as risk of loss from currency fluctuation or political or economic uncertainty. The Fund focuses its investments in specific regions or countries, thereby increasing the impact of events and developments associated with the region or country, which can adversely affect performance. Investments in emerging, offshore or frontier markets are generally less liquid and less efficient than investments in developed markets and are subject to additional risks, such as risks of adverse governmental regulation and intervention or political developments.

Investments in currency involve additional special risks, such as credit risk and interest rate fluctuations.

Derivative investments can be volatile, and these investments may be less liquid than other securities and more sensitive to the effect of varied economic conditions. While the Fund attempts to limit credit and counterparty exposure, the value of an investment in the Fund may change quickly and without warning in response to issuer or counterparty defaults and changes in the credit ratings of the Fund’s portfolio investments. The Fund’s investment in repurchase agreements may be subject to market and credit risk with respect to the collateral securing the repurchase agreements and may decline prior to the expiration of the repurchase agreement term. As this Fund can have a high concentration in some issuers, the Fund can be adversely impacted by changes affecting such issuers. Unlike typical exchange-traded Funds, there are no indexes that the Fund attempts to track or replicate. Thus, the ability of the Fund to achieve its objectives will depend on the effectiveness of the portfolio manager. Due to the investment strategy of the Fund, it may make higher capital gain distributions than other ETFs. Although the Fund invests in very short-term, investment-grade instruments, the Fund is not a “money market” Fund, and it is not the objective of the Fund to maintain a constant share price. Please read the Fund’s prospectus for specific details regarding the Fund’s risk profile

© WisdomTree

© WisdomTree, Inc.

Read more commentaries by WisdomTree, Inc.