Investors have become increasingly concerned about the impact of inflation and rising interest rates on stock markets. However, one of the less discussed side effects of higher interest rates is a stronger US dollar.
Recently, the US Dollar Index (DXY), which tracks the greenback against six major currencies, retested the 96.00 barrier after US inflation data rose to its fastest pace in four decades (at 7.5%) in January.
The US Consumer Price Index (CPI) data was also higher than the median estimate of 7.3%.
On a month-on-month basis, the index rose 0.6%, an indication that the Omicron COVID-19 wave has added to inflationary pressures.
Following the release of the CPI data, St. Louis Federal Reserve President James Bullard said he has become “dramatically” more hawkish and wants a full percentage point of interest rate hikes over the next three US central bank policy meetings.
This would require at least one half-percentage point rate hike, a big move that the Federal Reserve (Fed) hasn’t made in recent rate-hike cycles.
Prior to this, market participants have only expected the Fed to increase interest rate by 25 basis points in each of the three meetings.
This has led the 10-year US Treasury yield to breach the 2.0% level for the first time since August 2019.
Higher interest rates support stronger Dollar
Higher interest rates typically lift the dollar, which has helped the DXY to rebound from its recent downtrend.
Aside from that, the positive outlook for the dollar is supported by higher yields, persistent elevated inflationary environment, hawkish comments by Fed policymakers and the strength of the US economic recovery.
However, the market has already anticipated going “long” the dollar. This is reflected by the 5.98% increase in the DXY as compared to a year ago.
A more critical question surrounds the extent and duration of the dollar’s strength.
This is as recent hawkish messages from the Bank of England (BOE) and European Central Bank (ECB) could slow the pace of a move higher for the dollar index.
The market would also have to consider how other major central banks around the world will fight inflation that’s on the rise globally, driven by rising commodity prices.