The shocking truth about FED's interest rate policy and Dollar's value.

It has long been argued that the strength or weakness of the U.S Dollar depends largely on the Interest rate cycle that the FED is operating on. The theory being:

• A rate lowering cycle drives down interest cost to borrow the Dollar.
• The amount of Dollars in Circulation increases, Meaning a Weaker Currency value.

On the flip side,

• A rate raising cycle drives up the interest cost to borrow the Dollar.
• The amount of Dollars in Circulation decreases, Meaning a stronger Currency value.

This is the Basis of the Quantity theory of money. As we know, theories are always simple, and tempting to believe. But let’s try to explore the Facts.
In this article I will examine two things:

1. Does the interest rate trend predict the Dollar price trend?
2. Can the FED's interest rate decision be used as a trading tool or trade indicator?

The most useful method to examine if there is a correlation or not, is to simply compare the charts so lets start there.

The Dollar INDEX vs the FED's Discount Rate.

The above chart can be found HERE.
Lets break up the above time line into specific periods and examine what happened.

1995 to 2001.

From 1995to 2001 the Fed stayed pretty steady in is rate decisions, with an average rate of around 5%.
In that same time period the U.S Dollar index soared from a low of 90 in 1995 to a high of 125 in 2001.
The discount rate move +/- 100 basis points and the Dollar moved up by 3500 basis points or 35% in value.
Form the above information you might surmise that a steady interest rate policy is great for the value of the Dollar.

2001 to 2003

From 2001 until 2003 the FED lowered the discount rate from 6% all the way down to 0.75%. A dramatic drop of 525 basis points to the lowest rates in 60 years.
In that same period, the Dollar index first moved up by 500 basis points from125 to 130, and then dropped the same 500 basis points. back to 125 again. A net change of 0%.
From this time period you could say that an historic move downwards in the discount rate has very little effect on the value of the dollar.

2003 to 2007

From jan 2003 until june 2007 the FED hiked rates up consistently from the low of 0.75% to a high of 6.25%. An increase of 550 basis points. In the same period the Dollar Index fell in value from 125 down to 110, a drop of 1500 basis points or 12%.
The action in this time period might lead you to believe that a rising rate environment is, on balance, pretty bad for the dollar.

2007 to 2010.

This is of course the great recession period. rates started at 6.25% and again dropped precipitously to 0.5% by the beginning of 2010. this was an even bigger cycle drop than the 2001 drop. An overall decline of 575 basis points!
During this cycle of declining rates:

• the Dollar index first fell from 108 to 95 in june 2008. a decrease 1300 basis points or 14%.
• Then the Dollar index rose from 95 up to 113 in june 2009, a rise of 1800 points or 19%.
• then the dollar fell from the 113 high to 100 at the beginning of 2010, a fall of 1300 points or 13%

We can see here that another historic decrease in the discount rate is first badfor the dollar, then good, then bad again!

2010 to 2016.

We have now lived through 6 years of flat rates from the FED. and in that time the Dollar index has staged a huge rally. Going from 95 up to 125, a rise of 32% or 3000 points.

Again a flat period for rates leads to a huge Rally.

Can the interest rate trend be a good tradingindicator?

I think the only answer that question is a resounding No! there is absolutely no indication on a long term basis that the interest rate trend can influence the price trend.
To use the quantity theory of money as an indicator tool for trading the Dollar would be next to catastrophic for your trading account balance!

Lets say you foresaw the rate cuts in 2001, and you sold the Dollar because  lower rates are bad for the value of the currency. the market would immediately move against you by 500 points, could your account balance suffer these losses without a large margin call?
Lets say you then foresaw the huge rise in rates to come after 2003. You then bought the Dollar on the back of this rising rate cycle. What would happen? well the dollar would go on to lose 3000 points! Could you suffer that loss?
Lets say again that in 2007 a trader sees a massive rate cutting cycle straighta head and decides that this has got to be bad for the Dollar! He moves to sell the dollar, first the market goes with him by losing 1300 points then against him by 1800 points! What is a Trader to do to get some luck!

Conclusion.

There is no basis in fact that the cycle of rates that the FED is in at any time, has any correlation to what the Dollar actually does over that time.
So the Fact that this belief in a correlation still persists among institutional traders and analysts is Baffling to say the least.
The Kindest thing that can be said about the correlation between the two is that when rates are flat the dollar goes up! and nothing more.

The best action for traders is take the FEDs rate decisions with a pinch of salt, and not let them affect his/her view point on the market.
The evidence suggests the currency market is more powerful than the FED gives it credit for, and that the FED is less powerful than traders give it credit for!