The US dollar will keep rising – whatever the Fed does in 2015

published 18 December 2014

141218-yellen-2 — The Fed's Janet Yellen: interest rates will be low for a "considerable time"

It's nuts if you think about it too hard.

All across the world, things were happening yesterday with the potential to scupper the best-laid plans of investors everywhere.

Russia was still trying to prop up the rouble. The Greeks were having the first round of a presidential election that could end up triggering a general election and fears of a Greek exit all over again. And on a more positive note, Americans can now get hold of Cuban cigars legally once again.

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But despite all that, all anyone in the markets was really interested in was the status of two little words.

"Considerable" and "time"

Moving the market with two little words

Because that's how long the Federal Reserve expects to keep interest rates low for, after ending quantitative easing (QE).Or at least it was.

But the words were dropped from the notes on the Fed's latest interest-rate setting meeting. Instead, the Fed will now be "patient" in making a decision on when to start pushing rates up.

So what does that actually mean?

Janet Yellen, the Fed chairwoman, explained it. She said that it's "unlikely" the Fed will want to raise rates for at least the next couple of meetings. And that some committee members reckon that conditions will be ripe for a rise "by the middle of next year". But all in all, it just depends on the state of the economy.

What did markets make of it all? The S&P 500 rebounded strongly yesterday, getting back above the 2,000 mark after a rough week. But that had more to do with signs that the oil price and the rouble might be stabilising.

(I'm not convinced on this yet, incidentally anything that falls this hard and fast has got to pull up at some point, so there's no guarantee this is the bottom).

Really it was the US dollar's reaction that showed what investors thought of the Fed's new stance. It got stronger, suggesting that investors reckon the Fed might be raising rates sooner than it thinks.

The Fed has lots of excuses not to raise rates but it doesn't matter

But at the same time, I can see the dollar continuing to get stronger regardless. For a start, the economic data is likely to continue improving. Yes, the shale oil and gas boom might tail off. But consumers are already feeling the benefit of plunging oil prices, and given the shape of America's economy, that's likely to offset the negatives, in the short-term at least.

The other reason to expect a stronger dollar is a direct result of the plunging oil price. I was reading an interesting piece from Izabella Kaminska on FT Alphaville last night on petrodollars.

High oil prices funnel US dollars to oil-producing countries. These countries then need to invest that money. They stick some of it right back into the US. But because US interest rates have been so low, they have also been investing in more exciting' assets, like sterling, resource currencies, and emerging markets.

Take away the dollars from the oil producers, and the flow of money into those markets gets reversed. As a result, commodity currencies and emerging markets tank. Which is what's happened.

Meanwhile, anyone who has borrowed money in dollars, betting that the US currency would remain steady or weaken even further (a carry trade'in effect), is now on the painful end of a bad leveraged bet.

So with everyone getting jittery about risky' markets, and a general shortage of dollars in the world, the natural desire is to rush to the US the ultimate safe haven.

How the real' economy could benefit at the expense of the financial one

If that reverses, you have less money available for financial assets. But in the case of oil, you also have more money for consumers. And if that boosts consumer demand, then in turn you might get more classic inflation in consumer goods prices, rather than in asset prices.

And that in turn, would put more pressure on central banks to start raising interest rates.

That might take a while to play out, of course. But the strong dollar story isn't going away. For more on how to play it, you should read James Ferguson's recent story in MoneyWeek magazine.If you're not already a subscriber, get your first four issues free here.

John is the executive editor of MoneyWeek and writes our daily investment email, Money Morning. John graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news. John joined MoneyWeek in 2005.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.