A major indicator of market expectations for interest rates broke records yesterday after rising to 100% for the first time ever. A staggering US$2.1 trillion in total had been wagered on the Federal Reserve hiking interest rates to 0.75% in next month’s monetary policy meeting.
Investors are the most confident they have ever been that US interest rates are about to rise, 21% more optimistic than they were before the last hike, despite that move being much more widely telegraphed by Federal Reserve policymakers.
Markets are currently betting that the Federal Reserve is going to raise benchmark interest rates from 0.5% to 0.75%.
This is the interest rate the Federal Reserve expects US banks to lend money to each other; a bank that has depleted its funds during the day may borrow money overnight from a bank that has more capital spare.
Raising the amount of interest banks have to charge each other (0.75% is the ‘upper bound’ – the most a bank can charge) means financial institutions may not be able to afford to borrow as much. This reduces the amount of money in circulation between banks and therefore restricts the amount of new loans and mortgages issued.
With less money circulating the economy the ‘purchasing power’ of the US Dollar (i.e. how much it can buy) increases. This means USD exchange rates increase. This can reduce the profits of business and investors, who may therefore decide to ‘hedge’ against rising costs by entering contracts which allow them to buy US Dollars for a lower price than they expect it to be worth in the future.
It is by measuring how much of these contracts have been taken out to protect against rising prices that the odds of a rate hike are calculated.
Of course, it’s worth remembering that the 100% odds of a hike is simply what the market expects to happen. But there have been some pretty strong indications from members of the Federal Reserve that interest rates are headed higher. Nothing is certain – there could still be some kind of economic shock in the next few days that deters them from doing anything, for instance.
Investors looking for a profit are buying the US Dollar now because they are confident that interest rates will rise and push the value of the ‘Greenback’ even higher. This means, unless something dramatic should happen in the next few days to significantly undermine hopes of a rate hike, the US Dollar is likely to keep appreciating.
However, what has already been seen this week – and was evident before last year’s rate hike – is that some investors are beginning to worry that the US Dollar may have been overbought. There is a realistic limit to how high the ‘Buck’ can surge on the back of a rate hike before it plateaus. This is because many investors will begin selling the US Dollar to take profit on the strong appreciation.
Also, because it could be a while before the Federal Reserve hikes rates again, there will be nothing in the near-future to suggest that the US Dollar is likely to appreciate significantly, making other currencies more appealing. As investors sell out of the US Dollar in order to buy more promising currencies, US Dollar exchange rates are likely to weaken again.
If investors believe the markets have already reached the point where the US Dollar cannot go any higher, they may sell the ‘Greenback’ now, as the potential for profit is limited in their eyes. This could see the US Dollar weaken over the coming days, even if market expectations of a rate hike remain firm.
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