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By Nicholas Porter
The US dollar has been in the limelight lately, with the greenback climbing relentlessly against its developed market peers. The euro/dollar (EUR/USD) exchange rate is closely watched as an indicator of global sentiment and is the most traded currency pair in the world. The euro recently touched parity with the dollar this month, with one euro worth one dollar – a level not seen 20 years ago.
However, the euro is not the only one to depreciate against the dollar. Most majors have weakened throughout 2021. What is driving this trend and can we expect it to continue?
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Central banks around the world are facing mounting pricing pressures around the world. Real interest rates (represented by nominal rates minus inflation expectations in the chart below) fell across Europe and in the US
Nevertheless, countries face particularly idiosyncratic macroeconomic situations (take, for example, the natural gas crisis in Europe). As a result, policy responses have varied widely. The central banks that have been the most aggressive in fighting inflation have experienced concurrent relative strength in national currencies.
The Australian and Canadian central banks were among the most hawkish banks in developed economies in 2022, raising policy rates by 1.35-2.5% each. Their currencies performed relatively well against the dollar. Being major commodity exporters, of course, also helps. The ECB, meanwhile, just raised rates by 50 basis points for the first time in a decade, and the Bank of England rose 1.25%. These interest rate differentials (i.e. interest rates relative to the United States) and expectations of them are the primary drivers of dollar strength this cycle. The chart below illustrates economists’ expectations for US interest rates for one year, minus expectations for a second country.
Even those who don’t speculate directly in currencies should be aware of the major trends in the foreign exchange markets. Year-to-date, hedged exposure to Eurozone equities has outperformed unhedged exposure by 13%.
Indeed, a strong dollar has generally been a mixed bag for risky assets. The table below shows the next month’s average return and standard deviation for asset classes after the Bloomberg Dollar Index recorded a 10-year z-score of 1 or greater. In particular, investment bonds and gold are performing well: the strength of the dollar often coincides with risk-averse behavior and the search for safe havens, roles that bonds and gold generally fulfill. International equities and emerging equities are underperforming, which is almost tautological, although one might reasonably have expected some form of mean reversion after a period of local currency weakness. A strong dollar is also bad for commodities, which fits the theory perfectly – most commodities are denominated in dollars, and therefore a higher price leads to lower demand.
What is the outlook for continued dollar strength in the second half of 2022? Any hint of a global recession, additional geopolitical strife, liquidity or banking event would add to the dollar’s tailwinds via the safe haven role of the dollar. Much of the market, however, expects the Fed’s hike cycle to end in 2023, with rate cuts following a shallow recession. If a recession in the United States dampens domestic inflation, does not trickle down to the rest of the world, and causes the Fed to cut rates, the dollar will likely depreciate. Alternatively, the Fed could cap rates in early 2023 while other central banks continue to hike to catch up, which on net would be bearish for the dollar. In the short term, the likely path is down – there is plenty of evidence that the ECB needs to catch up, and the bulk of the Fed’s hikes are likely already behind us.
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