How Fed Rate Cuts Affect the US Dollar

The U.S. dollar recently touched an all-time low against the euro. Part of the reason is because the financial markets anticipate a rate cut from the Federal Reserve's Open Market Committee. That may not seem entirely clear, though. Why does a Fed rate cut drive down the dollar? (For a great explanation of how a Fed rate cut affects the stock market, see Jim's recent post at Blueprint for Financial Prosperity.)

Interest rates down – Dollar down

As interest rates fall, borrowing becomes cheaper. Correspondingly, lending becomes less attractive. The U.S. is the world's biggest debtor nation, meaning lots of other countries have loaned us money. When we pay back those loans with interest, we do so in U.S. dollars.

What all this means is that investors overseas have lots of dollars in their hands. When a rate cut occurs, investors holding U.S. dollars see lower returns. When your bank offers a savings account interest rate lower than someone else's, what do you do? You move your money to the other bank. Same thing here. Investors dump dollars in favor of some other currency. That drives down the value of the dollar relative to those other currencies.

What a weak dollar means to you

A weak dollar has several different effects, among them:

• Traveling overseas sucks for Americans because it costs much more. Conversely, anyone from another country vacationing in America loves it because their currency buys so many more dollars.
• Because oil is priced in dollars, the price of a barrel goes up. This is part of the reason oil has hit a record high recently.
• Overseas investments by Americans are more profitable. This is especially important for people who have a portion of their 401(k) or other investments in global mutual funds.
• American businesses that do much of their business overseas will be more profitable.