Why the Fed Would be Insane to Raise Rates: The Rising U.S. Dollar

The parlor game of the moment is laying odds on the Federal Reserve’s decision to raise rates, leave rates unchanged, or (gasp!) hint at future stimulus. There are certainly a multitude of inputs to the Fed’s decision, and a variety of potential consequences, but only one really matters: the effect on foreign exchange/currency markets.

It’s not that difficult to understand the one dynamic that matters. If the Fed raise yields/interest rates in the U.S., that makes the U.S. currency, i.e. the U.S. dollar (USD), more attractive.

Higher yield = more attractive, especially when coupled with the liquid market for U.S. Treasuries and the relative safety of the dollar vis a vis other currencies issued by falling-into-recession nations and trading blocs.

What happens when the Fed makes the USD more attractive to global capital? Capital flows even faster out of emerging economies and China. The tidal flow of capital out of emerging markets and China threatens to surge into a veritable tsunami should the Fed raise rates.

What happens as capital flees emerging markets and China? Bad things. Lots of bad things.

Number 1 Bad Thing: The currencies of emerging market nations weaken as capital flees, forcing the issuing nations to defend their currencies (a losing proposition, as we saw in the Asian Contagion of 1997-1998) or devalue their currencies.

We caught a whiff of what happens when China is forced to devalue the RMB/yuan–global markets went into a free-fall.

Number 2 Bad Thing: Investors sell emerging market stocks and bonds to escape the downside of currency devaluation. This crushes the stock and bond markets in emerging economies–and China, however you wish to categorize it.

Number 3 Bad Thing: Investment in emerging market economies dries up.

Global growth largely depends on the rapid expansion of emerging economies, which in good times can grow 5% to 8% annually, while developed economies register 1% or 2% growth at best.

Once capital flees, investment in fast-growing economies dries up and as a result, so does growth. The inevitable result is a global slowdown, a.k.a. global recession.

Number 4 Bad Thing: As the dollar strengthens versus emerging market currencies, a self-reinforcing feedback loop is established: the more the USD rises, the more capital flees emerging markets, pushing those currencies down, which then forces more liquidation of stocks, bonds real estate, etc. denominated in those depreciating currencies.

The USD strengthening since last July is the core driver of the global recession.Is the Fed insane enough to deepen the global recession by raising rates and pushing the U.S. dollar even higher? Who wins if the USD strengthens due to the Fed raising rates?

In a globally interconnected economy, nobody wins.