Exchange rate drivers | ETF Trends

By on August 8, 2022 0

By Nicholas Porter

Recent Dollar Trends

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?

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.


Astor Investment Management LLC is an SEC-registered investment adviser. All information contained in this document is for informational purposes only. This is not a solicitation to provide investment advice or services in any state where it would be illegal. Analysis and research are provided for informational purposes only, and not for trading or investment purposes. All opinions expressed are as of the date of publication and subject to change. They are not intended as investment recommendations. These documents contain general information and have not been adapted for a specific recipient. There can be no assurance that Astor’s investment programs will produce profitable returns or that any account will produce similar results. You risk losing money. Past results are not indicative of future results. Please refer to Astor’s Form ADV Part 2A brochure for more information on fees, risks and services.

The Astor Economic Index® : The Astor Economic Index® is a proprietary index created by Astor Investment Management LLC. It represents an aggregation of various economic data points. The Astor Economic Index® is designed to track the different levels of growth within the US economy by analyzing current trends against historical data. The Astor Economic Index® is not an investable product. The Astor Economic Index® should not be used as the sole determining factor in your investment decisions. The index is based on back data points and may be subject to back bias. There can be no assurance that the Index will produce the same results in the future. All conclusions are those of Astor and are subject to change. Astor Economic Index® is a registered trademark of Astor Investment Management LLC.

MAS-M-290096-2022-08-01

All information contained herein is for informational purposes only. This is not a solicitation to provide investment advice or services in any state where it would be illegal. Analysis and research are provided for informational purposes only, and not for trading or investment purposes. All opinions expressed are as of the date of publication and subject to change. Astor and its affiliates are not responsible for the accuracy, usefulness or availability of this information nor responsible for any transactions or investments based on this information. Please refer to Part 2 of Astor’s Form ADV for more information on fees, risks and services.