Question

In \(2017,\) an article on bloomberg.com had the following headline: "The Australian Dollar's Outlook Darkens." The article stated, "The march of the Fed toward higher U.S. interest rates has also been a factor sapping optimism toward the Aussie [dollar]." Briefly explain the article's reasoning.

Short answer

The march of the Fed towards higher US interest rates leads to the appreciation of the US dollar as it increases the demand for US investments. This results in the relative depreciation of other currencies, including the Australian Dollar if they don't experience a similar or higher rise in interest rates. Therefore, the darkening outlook for the Australian dollar means a potential decrease in its value compared to the US dollar.

Step-by-step solution

Understand the role of interest rates

Interest rates indicate the cost of borrowing. When a country increases its interest rates, financial foreign investors have an incentive to invest in that country to take advantage of the higher returns. This demand for their currency tends to increase its value.

Look at the March of the Fed

The term 'The march of the Fed' in the article represents the Federal Reserve's (Fed) actions to raise interest rates in the United States. When the Fed raises interest rates, investments in the US become more attractive leading to a higher demand for the US dollar. Consequently, the US dollar appreciates.

Effect on the Australian dollar

The rise of the US dollar implies a relative depreciation of other currencies against it, unless their respective economic factors change in a similar direction. Thus, if the Australian dollar does not experience a similar or higher increase in its interest rate, it will depreciate relative to the US dollar. This depreciation reflects as a 'darkening outlook' for the Australian dollar, which can discourage investments.

Key concepts

Interest Rates

Interest rates are the percentage charged on borrowed money or the return on investment gained by lending money. They are crucial in determining the flow of money across borders. When a country raises its interest rates, it becomes a more appealing place for investors to put their money. This is because investors look for opportunities where their funds can earn the highest returns.

For example, if the US raises its interest rates, investors might sell their currency holdings, like the Australian dollar, and instead buy US dollars to benefit from higher returns in the US. This shift can increase the demand for the US dollar, causing it to gain value, while the Aussie dollar may lose value. This aspect shows how interconnected global economies are, and how domestic policy changes in one country can affect currency values worldwide.

Interest rates affect not only currency appreciation and depreciation but also economic growth and inflation. Therefore, central banks carefully decide on changes in rates to stabilize their economies.

Foreign Investment

Foreign investment is the allocation of capital to another country with the expectation of returns. It plays a vital role in shaping currency exchange rates. When a country's economy offers competitive returns or stability, it attracts foreign investment. Investors buy that country's currency to invest, increasing demand for it and consequently its value.

For example, if the US raises its interest rates, it can attract more foreign investors seeking better returns than those available elsewhere. This increased investment increases demand for the US dollar, and as a result, its value appreciates in comparison to other currencies.

Investors consider factors like interest rates, economic stability, and potential for growth when deciding where to allocate their resources. Sudden or expected changes in these factors can result in significant shifts in foreign investment and thus currency values.

Currency Depreciation

Currency depreciation refers to a decrease in the value of a country's currency relative to others. It can happen due to various reasons, including changes in interest rates, economic instability, or increased foreign debt. When a currency depreciates, it can make imports more expensive and exports cheaper.

In the scenario where the US raises its interest rates, the Australian dollar may depreciate if no similar action is taken by Australia to increase its own rates. This depreciation means that the Australian dollar becomes less valuable compared to the US dollar, making goods imported from the US more costly for Australia.

This kind of currency shift can make international investments unstable and may dissuade investors from investing in countries with weaker currencies. However, a weaker currency can sometimes boost a country's export economy, as their goods become more competitive abroad. Balancing these factors is crucial for maintaining economic stability.