Swarup Kalluri

The year 2022 marked a significant shift in economic ideologies across many nations. The idea of de-dollarization gained traction, largely influenced by the conflict in Ukraine. The decision to exclude Russia from SWIFT and freeze their dollar assets by the USA highlighted the vulnerability of the dollar as a safe-haven asset. This led to a global push to reduce reliance on the dollar, with central banks worldwide increasing their gold reserves as part of diversifying forex holdings.

Despite these efforts, the world remains heavily dollarized, echoing Shakespeare’s sentiment of being “full of sound and fury.” The dominance of the US in the financial market is evident through the pivotal role played by the Federal Reserve. The Fed serves as a linchpin for central banks globally, with decisions made impacting markets worldwide. Any statement from Fed officials regarding future rate cuts or actions reverberates through bond yields, causing market fluctuations.

Changes in inflation rates, no matter how slight, send ripples across the globe, reflecting the belief that the Fed’s actions steer the flow of global funds. Signals indicating a delay in rate cuts spark market panic, leading to an increase in bond yields in the US and beyond.The process of transmission is straightforward. If the Federal Reserve opts against reducing rates, interest rates in the United States become more stable.

This serves as a cue for investors to allocate their capital here due to the superior returns. Consequently, there is a decrease in funds flowing to other nations, particularly the emerging markets. It is worth noting that following the quantitative easing initiated by the Fed after the Lehman crisis, investment funds shifted to emerging markets due to the availability of inexpensive funds and the opportunity to invest in countries with higher returns. This trend emerged when the Fed funds rate neared zero.

The scenario changed once the Federal Reserve chose to raise interest rates in 2022 and 2023, accompanied by quantitative tightening where the Fed refrained from purchasing new bonds but continued with rollovers. Hence, the interest rate indicated by the Federal Reserve is crucial for all market participants beyond the borders of the USA. The market accepted the rate hikes by the Fed.

However, when the pause was observed as inflation seemed to be decreasing, questions arose regarding when the Federal Reserve would decrease rates. The dot plot released suggests the possibility of three rate cuts this year, totaling around 75 basis points. Yet, due to uncertainties surrounding inflation, the message conveyed by the Fed is that it is not rushing to lower rates and aims to avoid a situation where lowering rates leads to a surge in inflation.The impact of high or increased interest rates in the United States on the value of the dollar and other currencies is a complex phenomenon. In theory, when interest rates in the US are high, or when they are increased, the value of the dollar tends to strengthen.

This is because higher interest rates attract foreign investors who seek higher returns on their investments. As a result, there is an increased demand for the dollar, which leads to its appreciation against other currencies. This appreciation of the dollar is often reflected in the dollar index, which measures the value of the dollar against a basket of other major currencies. When the dollar index rises, it indicates that the dollar has strengthened relative to these other currencies. However, the depreciation of other currencies in response to the strengthening of the dollar goes beyond the basic principles of demand and supply for dollars.

It is often driven by market sentiment and investor behavior, as well as factors such as geopolitical tensions or economic uncertainties in other countries. When other currencies weaken against the dollar, it can prompt central banks in those countries to intervene in the foreign exchange market. They may take measures to support their currencies, such as selling their own currency and buying dollars. This intervention can have implications for interest rates in those countries. In some cases, central banks may adopt a more hawkish stance on interest rates in order to support their currencies. A hawkish stance means that the central bank is more inclined to raise interest rates or keep them elevated. This is done to attract foreign investors and stabilize the currency.

The impact of these fluctuating sentiments and currency movements is felt by countries like India, which have close economic ties with the United States. In the bond market, there is a dual trend where short-term yields are influenced by liquidity conditions. However, the 10-year bond market tends to follow the lead of US Treasury yields. This correlation is likely to persist until the Federal Reserve actually begins to lower its policy rate. Overall, the relationship between interest rates, currency movements, and central bank intervention is complex and influenced by various factors. The impact on different countries can vary depending on their economic fundamentals and the specific circumstances at play.The currency on the opposite side is facing pressure as the dollar strengthens.

The underlying factors supporting the rupee seem stable, and there are positive prospects with the expected increase in FPI flows after June. However, the pressure is noticeable on a daily basis, and the RBI will need to actively intervene to control excessive volatility when it arises. This situation is not unique to other countries either, as they are also connected to the Federal Reserve and the US economy. This is due to globalization, which links all financial markets with the movement of investor funds, leaving a significant impact everywhere. That is why one cannot disregard the actions of the Fed, even though inflation targeting may vary across different regions, except for the influence of crude oil.