On Feb. 18, after the market closed, the Federal Reserve announced a change in monetary policy. According to the press relase, press release that "in light of continued improvement in financial market conditions the Federal Reserve Board had unanimously approved several modifications to the terms of its discount window lending programs." Changes included approval from the board of a 0.25-point increase to the primary credit rate, or discount rate, from 0.5% to 0.75%.
The markets reacted immediately. U.S. equity index futures traded lower, the dollar rose, and the price of gold declined. With a decision slated to come tomorrow from the Fed regarding interest rates, our task now is to take apart this previous action and the subsequent market reactions in order to understand them and their implications in greater detail. We need to ask ourselves: How can we take advantage of the implications of a change (actual or perceived) in monetary policy? We also need to ask: What does this mean for my investments? Let's take this one at a time. 1. Why did the dollar appreciate? When interest rates rise in a home country without corresponding changes in a foreign country, demand will increase for the home country currency. The reason for this is described in a theory referred to as interest rate parity, which deals with interest rate dynamics as they relate to currency exchange rates. Prior to the interest rate change, the currency exchange rates were in a state of equilibrium. Once a home country's rates increase, interest earnings for the home country currency will increase relative to the foreign country currency. The spot rate of the home country will then appreciate to reflect a no-arbitrage condition, and the currencies will return to equilibrium. Since U.S. interest rates are perceived to be rising, so will the dollar. The foreign exchange market is the most active market in the world. The number of transactions and monetary value of foreign exchange trades dwarf the market of any other security type (such as stocks or bonds). Individual investors can transact in the foreign exchange market in one of two readily available markets:
Using exchange-traded funds such as the PowerShares DB U.S. Dollar Index Bullish (UUP) ETF or the PowerShares DB U.S. Dollar Index Bearish (UDN) ETF