The US Federal Reserve has said that it has been patient with the US economy in terms of applying the brakes as far as interest rates are concerned. So far, in this low interest rate climate, there has been a lot of liquidity in the market, and this has resulted in an overheated stock market. This is obvious. Compared to Europe and Japan, American stocks are overvalued. In fact, it has gotten harder and harder to find a real bargain as far as price-per-earnings ratio and actual company growth are concerned.
With that said, it appears that the US Federal Reserve is measuring its wording very carefully to telegraph to the market that the days of really low interest rates are going to be over soon. The market has been responding quite effectively to this veiled messaging. You only need to look at the price of the dollar to see that the market is pricing in an eventual US Federal Reserve interest rate hike.
Since foreign exchange works on a purely comparative basis, if the US pays higher interest rates on dollar-denominated securities and assets, more global investors would flock to the US. Why? The Bank of Japan and the European central bank have been actively devaluating their currencies. While they are not on the record as saying that all their recent stimulus moves are intended to devaluate the value of the yen and the euro respectively, the net effect is the same. We are currently living in a currency devaluation environment.
It is easy to see why currency devaluation makes sense. If a country’s currency is cheaper, its exports are cheaper. Also, its debts are easier to manage. By devaluating its debts, it has to pay less real money for those debts. In light of the fiscal stimulus in Europe and Japan, the US, on the other hand, is going the other direction. It is thinking of raising interest rates. From a purely comparative basis, plus factoring in the relative strength of the US economy, it is no surprise that the US dollar has been on a tear recently.
I don’t see this pattern changing anytime soon because the fundamental global economic dynamics haven’t really changed. It has only been recently that Japan has shown some signs of healthy inflation. You can rest assured that, now that Japan is tasting the positive effects of currency devaluation, it will continue to do that for a long time to come. Expect the US dollar to strengthen even further. This is actually a net negative for the US because as the dollar strengthens, US products and US exports become more expensive and less attractive.
