When the U.S. Federal Reserve initiated an unprecedented wave of monetary easing since 2021, it signaled to various central banks around the world, as well as to different markets for goods, services, and securities, that the economic slowdown and weak employment levels are on the path of recovery. Lower policy rates cut borrowing and financing costs for a variety of investment projects, which boost growth rates. For the stock market, this meant less competition from banking sector products for portfolio investments. Similarly, in the real estate market, both the supply and demand sides became less vulnerable to leverage and, consequently, bubble bursts. Quantitative easing also stimulated expenditure, creating jobs and raising earnings among the working-age population. This resulted in a potential redistribution of wealth to younger generations and a better allocation of resources.

Conflicting Signals of Sharp Policy Rates Cuts

With inflation approaching the Federal Reserve's 2% target and signs of an economic slowdown, policymakers have indicated a series of rate cuts. Since July 2023, the policy rate has been between 5.25% and 5.50%, a level not seen since 2001. A recent Reuters poll of analysts suggested a shift towards expecting the Federal Reserve to cut interest rates by only 25 basis points.

The pace of interest rate cuts remains highly unpredictable. The Federal Reserve's 50 basis point reduction at the September 2024 meeting, along with hints of another 50 basis point cut in the next review, had an immediate impact on equities and gold markets. Consequently, assets priced in US dollars are expected to appreciate against a weaker currency. Similarly, signs of economic recovery were quickly reflected in the oil market. After dropping sharply to below $70 per barrel due to industrial sector growth figures in the United States and China, oil is now trading around $75.

Aggressive rate cuts, which are data-dependent, also raise concerns about the risks of a U.S. economic slowdown, which have recently increased significantly. In previous instances of substantial monetary easing, the outcome was inevitably an economic recession. Interestingly, JPMorgan noted that the dollar has typically surged after the Fed’s initial rate cuts in three of the last four cycles, challenging conventional expectations. 

The dollar’s future will largely depend on how US interest rates compare to those of other countries. Reuters surveys suggest that the interest rate discounts of the yen and Swiss franc to the US dollar might nearly halve by the end of 2025, while the British pound and Australian dollar may only gain a slight yield advantage over the dollar.  Economists also fear the large increase in money supply in the markets, which interest rates may fail to absorb, potentially leading to continued inflation rates above the average target of U.S. monetary policy.

Global Market Dynamics of US Fed Easing 

Unless the dollar becomes a low-yield currency, it will continue to attract non-US investors. Nevertheless, Asian economies have been leading the market’s expectations of US rate cuts, with the South Korean won, Thai baht, and Malaysian ringgit rising in July and August 2024. Additionally, China’s yuan has reversed its losses against the dollar this year.

In the commodities market, precious and base metals like copper could benefit from Fed rate cuts, driven by strong demand forecasts and a soft economic landing. Lower interest rates and a weaker dollar reduce the opportunity cost of holding metals and the cost of purchasing them in foreign currencies, potentially boosting momentum. High policy rates have been a significant obstacle for base metals, causing negative demand distortions from destocking and affecting capital-intensive end-demand segments. Precious metals, particularly gold, which has an inverse relationship with interest rates due to its investment demand, often outperform other commodities during rate cuts. Despite gold being at record highs, investors should remain cautious in their approach. 

US Monetary Policy Spillovers on Developing Countries

In a published study, Lim, Jamus Jerome, et al. (2014)[i] modeled the impact of quantitative easing policies in the United States and other high-income nations on gross financial inflows to developing countries between 2000 and 2013. Their research revealed evidence that quantitative easing might be transmitted through visible liquidity, portfolio balance, and confidence channels. The study found that quantitative easing accounted for at least 13 percent of the 62 percent rise in inflows between 2009 and 2013 due to shifting global monetary circumstances. Furthermore, the paper demonstrated evidence of heterogeneity across different forms of flows with portfolio (particularly bond) flows being more sensitive than foreign direct investments to the impacts of quantitative easing. 

The International Monetary Fund recently predicted that a reduction in Federal Reserve rates would eventually enhance bond flows to emerging and developing economies. As global interest rate conditions become more favorable for borrowers, Eurobond issuance and capital flows to these nations are expected to recover. BMI research house recently forecasted that, with the exception of Kuwait, Gulf Cooperation Council (GCC) central banks would lower policy rates by 50 basis points in the second half of 2024, starting in September, and by 200 basis points in 2025, in alignment with the US Federal Reserve. However, these predictions may now seem conservative, given the US Fed’s signals of potential additional cuts before the end of 2024, which GCC central banks are likely to follow. 

Lower US interest rates could foster development in the region. Countries with fixed exchange rate regime pegged to the dollar immediately adjusted their interest rates downward in response to the Federal Reserve’s decision. Most GCC countries follow a fixed exchange rate policy pegged to the dollar or a basket of currencies where the U.S. dollar represents the largest component. Consequently, these countries’ central banks aligned their decisions with the recent Federal Reserve move. 

Cutting interest rates in the GCC enhances their attractiveness to investors and supports initiatives to showcase the region’s vast potential. The “Invest UAE” campaign exemplifies recent efforts to increase the country’s appeal to foreign investors. According to UNCTAD, these efforts have significantly improved the UAE’s standing, placing it 16th among the top FDI recipients in 2022. This ranking aligns with the country’s high position among 190 nations in the 2019 Doing Business report. Lower borrowing costs due to reduced interest rates give the UAE and other Gulf countries a competitive advantage in drawing both direct and indirect foreign investments

The Global Lender of Last Resort

The widespread use of the US dollar grants the Federal Reserve additional leverage during crises. In today's interconnected financial world, monetary movements occur rapidly, as demonstrated during the pandemic. The Fed's provision of funds to other countries through swap lines helped stabilize dollar funding markets globally.

Swap lines, which are temporary loans between central banks, serve as a crucial financial safety net. In 2020, the Bank of Japan withdrew $225 billion from its swap line with the Federal Reserve. These loans, granted to certain international authorities, aim to prevent foreign disruptions from affecting the US economy, ensuring global dollar availability during crises.

If the European Central Bank (ECB) needs dollars, it can either use a swap line or sell its US Treasury securities. However, swap lines offer a preferable alternative to selling Treasury securities, which is less desirable. This mechanism helps stabilize the value of the dollar and other currencies. During the pandemic, swap lines contributed to nearly 20% of the increase in the Fed’s balance sheet

Other major economies, including those represented by the European Central Bank and the People’s Bank of China, also offer swap lines. China has extended swap lines to around 40 central banks, primarily assisting countries struggling to borrow in international markets. This network operates parallel to the long-dollar system, creating an alternative financial framework. 

Can De-Dollarization Facilitate Economic Independence from the US?

De-dollarization could help reduce dependence on the US economy. Currently, the US dollar dominates global foreign reserves and foreign exchange trades, with other currencies playing minor roles. However, several countries, particularly China, are actively working to lessen their reliance on the dollar through strategic monetary policies. 

Chinese companies like Li Ning and BYD are emerging as formidable competitors against global brands such as Nike and Tesla, respectively. This reflects China's evolving economic model, which once heavily relied on debt but now emphasizes exports. Furthermore, China is pushing to internationalize its currency, the renminbi, which currently accounts for 4.3% of global payments, compared to the dollar's 47% and the euro's 23%. 

The renminbi gains more traction when the dollar is used as a geopolitical tool, as evidenced by recent events involving Russia. Additionally, there is a growing movement towards central bank digital currencies, with the renminbi being a key example. While these digital currencies are unlikely to replace the dollar in the near future, it is worth noting that the dominance of dollar assets has decreased from 70% in 2000 to 60% today. Despite these shifts, no clear successor to the dollar's global dominance has emerged yet.