Janet Yellen & The Curious Case of the Rate Hike Conundrum

By Avirook Upmanyu

Last Wednesday, Janet Yellen, the Chairman of the US Federal Reserve, announced her decision to hike interest rates by a quarter-percentage point to a range of 0.75 percent to 1.0 percent. Central banks tend to raise interest rates when they have a positive outlook on the country’s economy. In theory, interest rate hikes should strengthen a country’s currency by signaling a positive economic outlook and making assets denominated in said currency more attractive. Despite this, the US Dollar weakened immediately after the rate hike, with the USD/EUR exchange rate falling from 0.9401 to 0.9314.

A second look suggests that the Dollar was overvalued going into the Federal Open Market Committee meeting last week because investors had priced in expectations of four rate hikes in 2017. At the meeting, Janet Yellen all but eliminated the possibility of four rate hikes in 2017 and hinted more along the lines of three rate hikes. Thus the markets flew too close to the sun—pricing in four rate hikes for 2017 into the USD, the markets had an incredibly hawkish outlook toward the US economy. In many ways, the Fed tempered these overly optimistic projections while simultaneously raising rates. This prompted a correction in the value of the USD relative to other major currencies, like the Euro, by weakening the Dollar.

On the other hand, the Dow shot up more than 100 points immediately after the Fed’s increase. Low interest rates have been widely considered a major factor in the Dow’s 220 percent surge over the past eight years. Falling expectations of interest rate rises appear to be giving the already buoyant equity markets a second wind, no doubt helped by the USD depreciation. Clearly the remaining interest rate hikes are not enough to curb investor optimism.