The core mechanism (why lower rates → weaker USD)

Interest rate differentials drive FX

Currencies move largely on relative yields, not absolute levels.

If:

• Fed funds rate ↓
• While ECB / BoJ / BoE stay the same or hike

Then:

• USD assets yield less
• Capital flows toward higher-yield currencies
• DXY tends to fall

This is classic carry trade logic.

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2. But here’s the big caveat (why it’s not mechanical)

A. Growth differentials matter

If rates are low because:

• The US is entering recession
  → Dollar may weaken

But if rates are low because:

• The US is structurally more productive
• Inflation is under control
• Growth is stronger than peers

Then:

• Capital can still flow into the US
• Dollar can stay strong despite lower rates

Example:

• 2010–2014: near-zero Fed rates, strong USD

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B. Risk sentiment often dominates

In global stress:

• Investors want USD liquidity
• USD strengthens even if rates are low

This is why:

The dollar is a “risk-off” currency

So paradoxically:

• Fed cuts aggressively
• Markets panic
• USD rallies

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3. Timing matters (this trips people up)

Before cuts

• Dollar often strengthens
• Markets price “US is doing better than others”

During early cuts

• Dollar can stay firm
• Especially if cuts are “insurance cuts”

Later in easing cycle

• Dollar tends to weaken
• Especially if global growth stabilizes

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4. Inflation vs nominal rates (important nuance)

FX cares about real rates:$$\text{Real Rate} = \text{Nominal Rate} – \text{Inflation}$$Real Rate=Nominal Rate−Inflation

If:

• Fed keeps nominal rates low
• But inflation also falls faster

Then:

• Real rates may still be attractive
• Dollar may not weaken

This is why “low rates” ≠ “weak dollar” automatically.

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5. What “weak dollar” actually means (people mix this up)

When someone says “weak dollar,” they might mean:

Meaning	Metric
FX value vs other currencies	DXY ↓
Domestic purchasing power	Inflation ↑
Trade competitiveness	Exports ↑

Low Fed rates primarily affect DXY, not inflation directly.

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6. Simple decision tree 🧠

Fed keeps rates low → does USD weaken?

• Rest of world rates higher? → Yes
• US growth weaker than peers? → Yes
• Global risk-on environment? → Yes
• Crisis / risk-off / USD liquidity demand? → No
• Inflation falling faster than abroad? → Maybe no

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Bottom line

• Low Fed funds rate biases the dollar weaker
• But FX is relative, not absolute
• Growth, inflation, and risk sentiment can overpower rate effects