But what does this spending shift, also called import substitution, have to do with the direction of the U.S. dollar? The answer lies in the combination of the external balance, or trade balance, and the internal balance, or unemployment rate. Those two balances, trade balance and unemployment rate, are “the two most fundamental variables for any currency,” said Woo in an interview.
As domestic demand increases, that spending can either focus on domestic or imported goods and services. A focus on domestic goods, as is currently the case, would lead to a decline in the unemployment rate, according to the note.
And here’s the tie-in to the Federal Reserve, which currently keeps interest rates low. The Fed has set an unemployment threshold (not trigger, as officials like to remind us) of 6.5% unemployment for a change in interest rates.
So the shift in spending habits, or import substitution, which is creating jobs and driving the unemployment rate lower, will eventually lead the Fed to hike interest rates and push the dollar higher. “Ultimately, for the dollar to strengthen, we need the Fed to hike rates,” Woo said.