Introduction
The decisions of the US Federal Reserve (Fed) play a decisive role in the global economy. By adjusting its interest rates, the Fed directly influences the cost of money, inflation, economic growth and, of course, the value of the US dollar (USD). These adjustments, whether rates rise or fall, are reflected in the world’s currencies, creating opportunities and risks on the foreign exchange (FX) market. In 2024 and 2025, traders will need to keep a close eye on these movements to adjust their strategies and take advantage of currency fluctuations, particularly seeking opportunities on FX markets in 2024-2025.
In this article, we will look at how changes in Fed rates affect the major currencies, suggest forex trading strategies and analyse the currency pairs most sensitive to US monetary decisions.
How do changes in Fed rates affect currencies?
The Fed’s monetary policy is one of the main drivers of fluctuations in the US dollar. An increase in interest rates generally means that the Fed is trying to fight inflation by making borrowing more expensive. This can have several consequences for the currency market:
- Increase in the value of the dollar: When the Fed raises interest rates, foreign investors often seek to invest in US assets to benefit from higher returns. This increased demand for dollars drives up their value. For example, in 2022, when the Fed aggressively raised rates to counter inflation, the dollar strengthened by more than 20% against several major currencies, such as the euro (EUR) and the pound sterling (GBP).
- Downward pressure on emerging currencies: Emerging economies with dollar-denominated debt often feel the effects of US rate hikes. A stronger dollar makes debt servicing more expensive, which can lead to capital outflows and a depreciation of these countries’ currencies. For example, in 2022, currencies such as the Argentine peso (ARS) and the Egyptian pound (EGP) came under significant pressure as a result of the Fed’s monetary tightening.
- Risk of increased volatility: Traders should also be prepared for increased volatility in FX markets during periods of rising interest rates. Rapid adjustments in monetary policy can create unpredictable swings in currency prices as investors constantly re-evaluate their portfolios.
Foreign exchange trading strategies during periods of rising interest rates
Against a backdrop of Fed rate hikes, traders can use a number of strategies to take advantage of currency movements:
Carry trade strategy
A carry trade involves borrowing in a low-interest currency to invest in another currency offering a higher return. For example, a trader could borrow in Japanese yen (JPY), where rates are historically low, to invest in US dollars or USD-denominated assets offering higher returns. When the Fed raises rates, this strategy becomes more attractive as the yield on dollar-denominated assets rises. However, this approach can be risky if currency volatility increases.
Trend monitoring
Rate rises tend to lead to strong directional movements in some currencies. Consequently, a trend-following strategy can be effective. For example, if the dollar starts to strengthen following a Fed announcement, traders could look to enter the market and follow this uptrend. It is important to set stop-losses to protect against a sharp correction or sudden change in trend.
Hedging
Traders who are exposed to several currencies can use hedging techniques to protect themselves against fluctuations in Fed rates. Using derivatives such as futures or options can help minimise potential losses if rate movements cause an unexpected devaluation in a currency in which they are invested.
Currency pairs most sensitive to changes in Fed rates
Certain currency pairs are particularly sensitive to the Fed’s decisions, and traders should keep a close eye on them in 2024 and 2025.
USD/EUR
The euro/dollar is the most heavily traded pair on the foreign exchange market. Fed decisions have a direct impact on this pair, particularly when there is a divergence between US monetary policy and that of the European Central Bank (ECB). When the Fed raises rates, the USD tends to strengthen against the euro, especially if the ECB maintains lower interest rates to stimulate the European economy.
USD/JPY
The Japanese yen is another currency that is highly sensitive to changes in Fed rates. As the Bank of Japan has maintained an ultra-low interest rate policy for several years, a rise in Fed rates often leads to a strengthening of the dollar against the yen. In 2022, for example, the USD/JPY reached its highest levels in 24 years, largely due to the divergence between US and Japanese interest rates.
USD/GBP
Sterling is also influenced by the Fed’s decisions. In 2022, when the Fed began to raise rates aggressively, the pound weakened against the dollar. However, the Bank of England also raised rates to fight inflation, creating a complex dynamic between the two currencies. In 2024-2025, traders will need to monitor the decisions of the two central banks to anticipate movements in this pair.
USD/CNY
The Chinese renminbi (CNY) is another currency to keep a close eye on. Although the People’s Bank of China (PBoC) tightly controls the value of its currency, movements in the dollar often influence trade and investment flows between the US and China. If the Fed continues to raise rates in 2024, this could put pressure on the CNY, particularly against a backdrop of slowing Chinese economic growth.
How can traders take advantage of monetary tightening and easing cycles?
The Fed can enter cycles of monetary tightening (raising rates) or monetary easing (lowering rates) depending on how the economy develops. Here’s how traders can take advantage of these cycles:
Monetary tightening
During a tightening cycle, interest rates rise, generally causing the dollar to appreciate. Traders can use strategies such as buying dollars against lower-yielding currencies (such as the Japanese yen or the euro) to take advantage of this strengthening. Monitoring Fed communications, including Jerome Powell’s statements and key economic reports, is essential for anticipating these moves.
Monetary easing
When the Fed enters an easing cycle, lowering rates to stimulate the economy, the dollar tends to weaken. In this case, traders can sell the dollar against currencies offering better returns or belonging to economies that are not undergoing a rate cut. Commodities, such as gold, can also become attractive safe havens for investors when the dollar is falling.
Conclusion
The Fed’s rate hikes are having a profound impact on currencies, particularly the US dollar. Traders must remain vigilant in the face of the Fed’s decisions, adjusting their strategies to navigate an ever-changing currency market. In 2024-2025, there will be plenty of opportunities for those who know how to take advantage of monetary tightening and easing cycles.
Thomas is a market analyst and self trader serving the community with his analysis and educational content from long time. The author has great exposure to different financial markets. He’s well-known for his day trading reviews and multiple timeframe analysis.
