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The U.S. Dollar and the Interest Rate Differential

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The U.S. interest rate differential and U.S. dollar normally move in tandem, but the relationship broke down for a stretch in April when tariff announcements prompted investors to shed American bonds, sending bond yields soaring and the dollar plummeting. —economist.com

 

Answer the following questions to check your understanding of the story.

1) Why do the U.S. interest rate differential and the U.S. dollar often move in tandem?

When the U.S. interest rate differential increases ___________.

Wrong! - What is the U.S. interest rate differential?

How would an increase in the U.S. interest rate differential influence the demand for U.S. assets? Would more Americans want to hold currency? Would Americans want to hold foreign assets?

Good Job! - The U.S. interest rate differential is the U.S interest rate minus the foreign interest rate.

When the U.S. interest rate differential increases, people can make more interest on U.S. assets compared with foreign assets. People buy U.S. assets and others who already hold U.S. assets keep them. The demand for U.S. dollars increases and the supply of U.S. dollars decreases. The U.S. dollar appreciates.

2) Why did investors selling American bonds cause bond yields to rise?

Investors selling bonds caused bond yields to rise because ____________.

Wrong! - How does selling bonds influence their price? Are bond prices and bond yields related? Are bond yields set by Federal Reserve decision or are they determined by supply and demand in the bond market?

Correct! - A bond is a promise to make specified (fixed) payments on specified dates.

The bond yield is the rate of return on the bond, which equals the fixed interest payment received divided by the bond price. As investors sell bonds, the supply of bonds increases. The price of the bond falls and the bond yield rises.

When the U.S. interest rate differential increases, people can make more interest on U.S. assets compared with foreign assets. People buy U.S. assets and others who already hold U.S. assets keep them. The demand for U.S. dollars increases and the supply of U.S. dollars decreases. The U.S. dollar appreciates.

3) In April, after tariff announcements, bond yields rose but the dollar fell. Why was there a break in their usual “tandem” relationship?

Wrong! - How does the demand for U.S. dollars and the supply of U.S. dollars change when the dollar exchange rate is expected to rise? How does a surge in the demand for U.S. bonds influence the value of U.S. dollar? If traders expect U.S. exports to increase, won’t the demand for U.S. dollars increase?

That's Right! - A fall in the expected exchange rate decreases the profit that traders expect to make by holding U.S. dollars. The demand for U.S. dollars decreases and the supply of U.S. dollars increases. The dollar depreciates.

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