The Correlation Between Fed Rate and the Value of the USD

Many traders and market analysts closely monitor the Federal Reserve's (Fed) interest rate policies, hoping that rate hikes will trigger a rally in the U.S. Dollar (USD). However, analysis indicates that this relationship is not always as strong as expected. Kathleen Brooks from Forex.com, in a note published on August 17, 2015, reviewed the Fed rate hike cycles of previous years and identified an interesting pattern.

History of Fed Rate Increases and Their Impact on the USD

The following is the analysis of Fed rate hike cycles that occurred in 1987, 1994, 1999, and 2004:

• 1987: The Dollar fell in the months following the rate hike.
• 1994: The Dollar moved sideways before experiencing a slight upward trend.
• 1999: The Dollar continued the upward trend that had already begun before the Fed raised interest rates.
• 2004: The Dollar experienced a decline as the Fed initiated its rate hike cycle.

What Does This Mean for Traders?

From this analysis, several key points should be understood by traders:

1. Caution in Relying on the Fed: Traders should not rely solely on the Fed's decisions to determine the short-term direction of the Dollar.
2. Previous Trends Matter: When the Fed starts raising interest rates, the Dollar tends to follow the dominant trend that has already been established.
3. No Direct Relationship: A rate hike by the Fed does not necessarily lead to a stronger Dollar. If the Dollar is weak during a rate hike cycle, that weakness often predates the hike.
4. Mild Reactions: Brooks projects that the reaction to a potential Fed rate hike may not be very significant.

Next Question: Where Will the Dollar Move?

If the Fed does raise interest rates in September (though this is still debated), history shows that there is no guarantee the Dollar will react significantly. However, since the Dollar has been on a rally approaching this event since mid-2014, there is a possibility that it will continue to rally in line with the Fed rate hike cycle. Nevertheless, this movement may not be heavily influenced by the Fed's decision itself.

Understanding the relationship between the Fed rate and USD movement is crucial for traders. Although historical patterns indicate that the Dollar does not always react as expected to interest rate changes, other factors, such as previous trends and global market conditions, continue to play a role. Therefore, traders should remain vigilant and not rely on a single factor when making trading decisions.

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