For example, US interest rates can hurt the dollar

The interest rate on US government bonds has reached the highest level in more than fifteen years. That is now a boost for the dollar. Due to the increasingly high interest costs of the growing national debt, this tailwind may eventually turn into a headwind.

When it comes to interest rate fluctuations, central bankers have been stealing the show in recent years. Financial markets are holding their breath in the run-up to new interest rate decisions by the European Central Bank (ECB) and especially the Federal Reserve in the United States. However, this week it was not the short-term policy interest rate that was in the spotlight, but rather the long-term interest rate that is determined on capital markets. There, the interest rate on US ten-year government bonds briefly rose above 2007% for the first time since 4,8. The increase in interest rates is partly the result of economic factors. Such as averting a shutdown in the United States and expectations that inflation will remain somewhat higher in the future than the stock market had expected.

1.000 billion in government bonds
However, another factor also plays a major role in the rising capital market interest rates. The U.S. Treasury Department likely raised more than $1.000 trillion from issuing government bonds in the third quarter. That is a quarter more than what it looked like at the beginning of the summer. By the way, it is certainly not a record, because during the corona pandemic in 2020, the United States issued almost $3.000 trillion in new loans. The large supply of government bonds causes bond prices to fall somewhat, which then pushes interest rates up on capital markets.

Dollar strength continues
Higher interest rates are usually positive for a country's currency. This applies to both the short-term policy interest rate and the long-term capital market interest rate. Because it looks like American interest rates will rise further and remain high for longer than expected, the dollar has been gaining ground again in recent months. Since mid-July, the currency has risen by almost 7% against the euro. Many parties expect the roles to be reversed in 2024, as they assume that American interest rates will also fall faster than European interest rates. However, that is not a foregone conclusion when you see how resilient the United States economy is. Moreover, the dollar often performs well in periods when the pace of growth in the rest of the world is weakening.

Interest payments will soon exceed defense spending
In the long term, however, rising capital market interest rates as a result of a rapidly increasing national debt is not automatically favorable for the dollar. Currently that debt is about $33.500 billion, or 120% of GDP. The country already spends almost as much on interest payments as on defense expenditure. If the debt burden rises too high, investors may doubt whether the United States can meet all repayment obligations in the future. Of course, that hasn't happened yet. But the recent credit rating downgrade from AAA to AA+ by rating firm Fitch indicates that a big tailwind for the dollar could eventually turn into a headwind.

Joost Derks

Joost Derks is a currency specialist at iBanFirst. He has over twenty years of experience in the currency world. This column reflects his personal opinion and is not intended as professional (investment) advice.

© DCA Market Intelligence. This market information is subject to copyright. It is not permitted to reproduce, distribute, disseminate or make the content available to third parties for compensation, in any form, without the express written permission of DCA Market Intelligence.