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Can You Imagine The Fed Raising Rates In This World? Currency Crisis Edition

A month ago China's stock bubble was bursting and Greece was imploding. Yet the US Fed, in a violation of both headline sentiment and common sense, was still promising to raise interest rates come September.

Fast forward to this week. China's surprise currency devaluation has sent the global markets into a tailspin, but rather than spiking on the sudden drop in a major trading partner currency, the US dollar is plunging against the euro and most other currencies. Why? Because a global currency crisis is just about the last situation in which the world's major central bank would be expected to tighten.

Suddenly, traders are concluding that maybe rates won't rise after all:

Fallout from China's yuan devaluation weakens dollar

(MarketWatch) - The dollar weakened against most of its emerging-markets and industrialized rivals Wednesday as investors fretted that China's devaluation of the yuan could cause Federal Reserve officials to delay an expected increase in their benchmark interest rate.

The ICE U.S. Dollar index DXY, -1.16% , a measure of the dollar's strength against a basket of six rival currencies, was down 1% to 95.9920.

China's decision to let the yuan drop caused emerging-markets currencies in Asia and elsewhere to depreciate in sympathy, as some investors anticipated central banks around the world will shift to a more accommodative monetary policy. This would push the dollar even higher, which could cause the Federal Reserve to hold off on raising interest rates for fear that the dollar has become too much of a drag on U.S. economic growth.

"The China move on FX, rightly or wrongly, is being seen as something that's muting the policy divergence theme," said Josh O'Byrne, G-10 FX Strategist at Citigroup.

Speculators unwinding bets on emerging-markets currencies also helped push the dollar lower, as they bought back the euros and yen they had used to fund those trades, said Jane Foley, senior currency strategist at Rabobank.

The euro EURUSD, +1.3222% rose 1.4% to $1.1197 from $1.1044 late Tuesday in New York, while the dollar shed 1% against the yen USDJPY, -0.94% to trade at ¥123.88 down from ¥125.07 late Tuesday.

So now we have currency turmoil in the developing world, equity corrections and possibly bear markets in the developed world, and deflation pretty much everywhere. None of this argues for a stronger dollar or higher interest rates.

Even before the latest shock, the Fed was starting to accommodate this view by sending out talking heads to make the soften the September rate hike. From MarketWatch over the weekend:

...But comments from Federal Reserve Vice Chairman Stanley Fischer on Monday may have helped ease some of those concerns. He told Bloomberg TV he doesn't expect the first interest-rate hike by the U.S. central bank in more than nine years to occur until after inflation returns closer to the Fed's target of around 2%.

Another week like this one and the idea of any central bank anywhere raising interest rates will be laughed out of the room.

 

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