Forex Trading Fundamental Analysis on US Dollar Interest Rates

When we discussed US Treasuries, we mainly talked about these foreign governments that buy US Treasuries. This is natural. If the United States issues Treasuries, there must be foreign governments or other investors to buy those Treasuries. But strangely it is usually the US government itself, specifically the US Federal Reserve to buy those Treasuries.

This may seem strange, but the largest holder of US Treasuries is indeed the US government itself. Overall, the US currently has over $8.2 trillion in outstanding Treasury debt, of which over $3.4 trillion is held by the Federal Reserve. This represents almost half of the total US national debt.

This is a good example of why you can’t point to the total US national debt and then say that the number is too large and dangerous. It is hard to believe that the US government would default on its debt when it is the largest holder of its own debt. Now, you may ask why the Fed holds such a massive of US Treasuries, and the answer is interest rates.

The Fed uses its holdings of US Treasuries to conduct monetary policy.

The Federal Reserve is responsible for maintaining interest rates at the level decided by the Federal Open Market Committee. The Fed controls a supply of over $3.4 trillion in Treasuries, and it buys or sells millions of dollars worth of US Treasuries on the open market every day for the purpose of adjusting or maintaining interest rate levels.

If the Fed wants to raise interest rates, it sells a net amount of Treasuries; if the Fed wants to lower interest rates, it buys a net amount of Treasuries. Before a central bank is established and functioning, the economy is prone to big ups and downs. Economic booms usually bring hyperinflation and subsequent recessions. By the time depressions and recessions were confirmed, it was already difficult to get the economy out of its downward spiral.

Fortunately, we have central banks that can step in and iron out the boom and the bust economic cycle. While the system is not perfect, it still provides a less risky economic environment, one that is the best possible attainable in which the economy can continue to prosper.

Suppose the Federal Reserve believes that the economy is growing too fast and may be overheating. If the economy overheats, inflation will spike and the economy will stagnate and go into recession. To prevent this from happening, the Fed would try to reduce the amount of money in circulation in the economy. The less money there is in circulation in the economy, the fewer people can spend. And the fewer people have to spend, the slower the economy will grow.

To reduce the amount of money circulating in the economy, the Federal Reserve sells US Treasuries. When the Fed sells US Treasuries, it recovers the money in the hands of the purchasers and stores it. This reduces the supply of money. And when the supply of money decreases and demand increases or stays the same, money becomes more valuable and interest rates rise.

The same principle applies when the Fed believes that the economy is in a significant downturn and may stagnate. If the economy stagnates, a recession or slump will set in and inhibit any possibility of economic recovery. The more money there is in circulation in the economy, the more people can spend. And the more people can spend, the faster the economy will grow. So to pump money into the economy, the Federal Reserve buys US Treasuries. When the Fed buys US Treasuries from sellers for cash, it recycles the Treasuries and stores them.

This increases the supply of money while demand remains the same, the value of money decreases, and interest rates are lowered. Although buying and selling US Treasuries is just one of the instruments used by the Fed to control interest rates, it is a very efficient and widely used one.

Fundamental analysis tool: target interest rates

Interest rates in the US have a more direct impact on the value of the US dollar than other fundamental factors. An increase in the target rate will lead to an appreciation of the dollar and a decrease in the target rate will lead to a depreciation of the dollar. Knowing this, you may want to keep an eye on this target rate. Here are a few charts that show how a change in the target rate would be reflected in a change in the supply and demand graph for the dollar. First is the basic supply and demand graph (See below).

When the Fed decides to raise the target interest rate, you know that the supply of dollars will decrease because the Fed will sell US Treasuries to recover dollars. When the supply of dollars decreases, the dollar appreciates. You can see in the chart below how the dollar appreciates when we reduce the supply of dollars.

When the Fed decides to lower the target interest rate, you know that the supply of dollars will increase because the Fed will buy US Treasuries to inject money into the economy. When the supply of dollars increases, the dollar will depreciate. You can see in the chart below how the dollar depreciates when the supply of dollars is increased.

International capital flows data and target USD interest rates allow you to better understand what is happening with US Treasuries and the impact on the US dollar. It is very easy to keep track of these two tools because international capital flows data is only updated once a month and the Federal Open Market Committee only meets eight times a year to determine interest rates.

When one of these two figures is updated, you have to ask yourself, “How will this news affect the supply of dollars and the demand for dollars?” Once you have answered this question, you will be able to predict the future movement of those currency pairs that are linked to the US dollar. In the long term, by staying concerned about these two instruments you will be able to make huge profits from the forex market.

Remember, these two fundamental analysis tools are only the beginning of all the tools you will use to invest in forex. We will be introducing 7 more fundamental analysis tools, while technical analysis tools will be discussed late.