Why an interest rate freeze could be deadly for the dollar

published 10 October 2007

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There was much rejoicing on Wall Street yesterday.

The Federal Reserve hiked the key US interest rate by a quarter point to 5.25%, as was expected (albeit, not until very recently). But what had traders dancing in the aisles was the accompanying statement. The Fed suggested that it might - just might - pause at the next meeting, depending on inflation data.

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That may sound reasonable to most people. After all, it makes sense to wait until all the facts are in front of you before you make any decisions. But even the possibility of a pause got Wall Streets hopes up, especially as markets had actually priced in a 12%-16% chance of a 0.5% hike this time round.

Fears that the Fed will raise rates too far' and plunge the US into recession may have eased for now. But of course, theres more than one way to crash an economy...

The Dow Jones Industrial Average jumped by more than 200 points on hopes that the Fed's interest-rate rising cycle may almost be done, as investors became giddy at the thought that "helicopter" Ben Bernanke won't let them down.

(In case you're wondering, the nickname comes from a 2002 speech in which the new Fed chief said that, if necessary, the US central bank could stave off deflation by printing dollars and dropping them across the US from helicopters).

But Mr Bernanke has more than the stock market to worry about. While stocks were soaring, the dollar went into a tailspin.

Peter Frank, senior currency strategist at ABN Amro told Bloomberg: 'We have the Federal Reserve talking down growth whereas in other economies they have said very different things. That's very negative for the US dollar.'

Similarly, Max Smith at the foreign exchange desk at Calyon Financial said: 'Funds are selling the dollar. The weaker Fed statement has triggered sales here.'

The trouble is that the US is deeply in debt. Its current account deficit now stands at more than 6% of gross domestic product. That's much higher than the 4% or so that most economists believe represents a danger point. The US needs to keep attracting foreign investors' savings in order to sustain that deficit.

But what happens if foreign investors decide they no longer want to prop up a countrys over-spending habits? You just need to take a look at what's been happening in Turkey over the past month or so to find out.

If you've recently booked a summer holiday there or to New Zealand, Hungary or Iceland for that matter - you might be rather pleased by recent events. £1 sterling would have bought you 2.35 Turkish lira on June 1st. It'll now fetch you around 2.95. That's a 25% jump in the UK tourists buying power in less than 30 days.

Unfortunately, while beach-bound Britons might be cheering, the people who actually have to live and work in Turkey won't be quite as happy. The country's interest rates have been hiked three times this month - twice this week alone. And we're not talking little US-style quarter point hikes here.

At the start of June, the key Turkish rate stood at 16.25%. It's now 22.25%.

The country is trying to stem the plunge in its currency, which has lost a fifth of its value since the start of April, pushing inflation up to 10%. The Turkish central bank has set itself an inflation target of 5%.

Why has it plunged? Easy money allowed countries like Turkey to run large current account deficits because their interest rates were higher than most other countries. Speculators borrowed money effectively for free in Japanese yen (you can read more about the 'yen carry trade' here: How stoozing could bring down the global economy) and bought into high-yield' currencies like lira and New Zealand dollars. But now that interest rates are rising everywhere, this hot money' is pulling out as exchange rates threaten to move against them.

As Andy Xie of Morgan Stanley puts it: 'Turkey appears to be the first emerging economy in a liquidity crisis. Several more could follow. The easy liquidity lulled a number of emerging economies into depending on portfolio inflows to fund their consumption through consumer credit. As the inflow stops, these economies will have to raise interest rates substantially to curtail their consumption.'

Now the US isn't an emerging economy. But it's been doing exactly the same as Turkey - relying on foreign savings to fund massive overspending by consumers and government. As Turkey is finding out, once the foreigners stop being so free with their savings, the money has to be found from somewhere. And that means tightening credit conditions to force your own citizens to start saving and stop spending.

You can read more about why the US current account is important from Jeremy Batstone at Charles Stanley - just click here: Why investors should keep looking East. And to find out how to profit from a falling dollar, see the article from Dan Denning, further down this email.

Suffice to say, 'helicopter' Ben Bernanke may need to take some lessons from his Turkish counterpart before its too late.

Turning to the wider markets...

Over in continental Europe, the Paris Cac 40 rose 106 points to 4,880, while the German Dax jumped 124 to close at 5,581.

Across the Atlantic, US stocks rallied strongly. The Federal Reserve hiked the key interest rate to 5.25% but hinted that there may not be another rise in August. The Dow Jones Industrial Average jumped 217 to 11,190, while the S&P 500 closed 26 points higher at 1,272. The tech-heavy Nasdaq gained 62 to 2,174.

The excitement continued in Asia. The Nikkei 225 gained 384 points to 15,505. Exporters jumped on hopes that US interest rate hikes may ease off for now. Inflation data also showed that prices in Japan rose at the fastest pace in eight years, with core consumer prices (excluding fresh food costs) rising at an annual rate of 0.6% in May.

This morning, oil was higher in New York, trading at around $73.80 a barrel, while Brent crude also rose, to trade at around $73.20.

Meanwhile, spot gold leaped as the dollar dived, bursting back through the $600 an ounce mark to trade at around $601. Silver also gained, to around $10.75 an ounce.

And in the UK this morning, the Office of Fair Trading said it is launching an investigation into airports. The sector is dominated by airports operator BAA, which has just been bought by a consortium headed by Spanish builder Ferrovial. Nearly 66% of UK air passengers begin or end their journey at a BAA airport, said the OFT.

And our two recommended articles for today...

Could the UK's debt mountain trigger a recession?

- UK homeowners now owe more than £1 trillion in mortgage debt. Household debt as a whole now exceeds our annual gross domestic product. Does it matter? Unfortunately it does - MoneyWeek's Cris Sholto Heaton explained why in a recent issue. To find out how the debt mountain could drag the UK into recession, click here: Could the UK's debt mountain trigger a recession?

How to profit from a falling dollar

- A few investors around the world are starting to notice that the US borrows a lot more money each year than it pays back, says Dan Denning in The Daily Reckoning. And some of them are beginning to realise that US debt is a lot riskier than most people think. As Asian bankers pull out of dollars, there's one place they're certain to go. To find out what it is, and how to take advantage, click here: How to profit from a falling dollar

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.