Higher interest rates are not always positive for the exchange rate
At first glance, the outlook for next year appears positive. Economic growth of around 1% is expected for Europe and over 2% for the United States. The general expectation is also that long-term interest rates will not change much, especially since inflation is widely expected to decline gradually. This provides a favorable backdrop for equities, and this expectation has recently been reinforced by:
- better-than-expected U.S. inflation figures;
- an oil price that, from a technical chart perspective, appears on the verge of breaking downward.
If this happens, a further decline of $10 to $15 can be expected. Should this trend continue, it would give central banks additional room to cut interest rates further.
However, the situation is more complicated. To begin with, no one really knows the true state of the U.S. economy. Due to the government “shutdown,” the data that have already been released and those that will appear before January are highly unreliable. For example, the inflation figure released in the U.S. this week says virtually nothing. The government had already decided not to calculate inflation for October and instead assumed that inflation in that month was 0%. This automatically pulls down the inflation figure for November significantly.
Many other economic indicators are also unreliable. As a result, no one knows how strong or weak the U.S. economy really is. Both the government and the Federal Reserve, however, are extremely afraid of a recession, so one may assume that in this uncertain situation they will stimulate too much rather than too little. For the time being, this creates an extra favorable climate for equity markets.
This also means that, after some time, a combination of overheating, rising inflation, and persistently large government deficits could emerge. Trump will likely appoint Fed members who would also want to keep interest rates low in such a scenario—something gold would certainly not welcome—but it is far from certain whether they would gain a majority within the Fed.
More important, however, is how long-term interest rates would react. Looking at history, these would rise regardless of the Fed’s response. This would ultimately force the central bank to raise short-term interest rates as well.
Assuming that this indeed happens at some point in the course of 2026, the next question is how markets would respond. In our view, poorly—both in bond markets and in equity markets. But what would this mean for the U.S. dollar? Normally, higher interest rates are positive for a currency’s exchange rate.
But consider what has happened recently with the Japanese yen. For quite some time, there has been downward pressure on U.S. interest rates and upward pressure on Japanese interest rates. Under normal circumstances, the dollar/yen exchange rate should have fallen as a result. This has not happened, or hardly at all. After the Bank of Japan’s interest rate hike at the end of this week, the exchange rate even rose sharply.
It is primarily government finances that are throwing a wrench into the works. With a very high level of government debt relative to GDP and a large budget deficit, the situation is quite poor. This might be manageable if the economy were growing strongly and tax revenues were rising rapidly. But that is not the case. On the contrary: higher interest rates slow economic growth.
The most important effect, however, is that government interest expenses rise very rapidly. This is not only because new borrowing comes with higher interest rates, but also because maturing debt has to be refinanced at higher rates. This leads once again to persistently large deficits, which in turn push interest rates even higher, and so on.
The central bank then has no choice but to finance an increasing portion of the deficit by creating money. This results in rising inflation and a weaker currency.
It strongly appears that this dynamic is playing a role in the case of the yen—at least the fear that things may move in this direction. We also interpret this as a warning sign for the rest of the world, especially the United States. Higher interest rates can have a very different effect than people are used to.
