- Rate hikes and safe-haven status have buoyed the US dollar
- But the end of the Fed tightening cycle could see the dollar weaken
Why is the dollar so strong? With the 75bps Fed rate hike fresh in our minds, high interest rates seem the obvious place to start. Since investments tend to flow to higher-yielding currencies, rising US rates have been a significant driver of dollar strength. But this isn’t the whole story, as the Swedish Riksbank shows. The Swedish central bank surprised markets with a 100bp rate rise on September 20, a move that ING FX strategist Francesco Pesole said could be “read as an attempt to lift the battered krona”.
But according to Pesole, the move “blatantly failed”: monetary policy moves could not overcome the market’s bearish take on European high-beta (ie more volatile) currencies. Capital Economics’ senior markets economist, Jonathan Petersen, doubts that rate hikes by either the Riksbank or Norway’s Norges Bank can do much to support the Scandinavian currencies in the future, given their sensitivity to the global business cycle.
The dollar, on the other hand, tends to perform well when global recession concerns escalate and risk appetites weaken. Goldman Sachs economist Kamakshya Trivedi argues that this is what makes the US dollar “special”. According to Trivedi, dollar strength in the first quarter of the year was driven by aggressive Fed hikes, while Q2 appreciation had a “recession-type flavor” as concerns about a global slowdown intensified. More recent gains have been driven by big Fed moves, which are again supporting the dollar against major currencies.
The greenback is now so strong that Trivedi argues “on a valuation basis, the dollar does look overvalued”. And as my chart shows, some currency pairings are particularly extreme: the dollar is nearing its historical high against the yen, and recently reached a 37-year high against sterling as the pound tumbled to $1.1233. The pound has since fallen below $1.10.
Capital Economics’s Petersen expects the strong run to continue over the short term. He argues that “our downbeat view on global economic growth suggests to us that continued weakness in risk sentiment could push the dollar to new cyclical highs before long”. High rates also look set to strengthen the dollar until the end of the tightening cycle: the Fed’s latest projections suggest a terminal rate of 4.6 percent in 2023 – front-loaded with around 125bps of hikes over the final two meetings of the year.
As the Fed takes “rapid and forceful steps to moderate demand” in the US, the strong dollar provides a helping hand. Trivedi argues that “a strengthening dollar is often part of any tighter financial conditions mix that policymakers focus on when they’re trying to slow the economy”. What’s more, the stronger dollar has kept the price of imports lower for those in the US – a boon in times of rising inflation.
Yet Goldman’s Trivedi argues that we are probably in the “later innings of this cycle of dollar strength”. Fund manager Bill Gross made headlines last week when he pointed out that the Fed can’t raise rates forever. Gross told investors that “continued large trade deficits and a ceiling on the Fed’s ability to raise rates to anticipated levels due to future recession will limit further depreciation of the pound and likely lead to future relative increases compared to the dollar”.
But a rally looks unlikely in the short term, for sterling at least: the pound struggled after the Bank of England announced a lower than anticipated 50bps rate hike. That stands in contrast to the increasingly hawkish tone taken by Fed chair Jerome Powell. A raft of issues have spooked markets in recent weeks, and uncertainty remains high. ING economists argued that “concerns over unfunded government giveaways and debt sustainability challenges could well see the pound continue to underperform this year” and anticipate that a stronger dollar will see sterling fall to $1.10. That, as it happened, took place the very next day.
The end of the Fed tightening cycle may, then, bring little relief: thorny issues are worrying sterling investors. The UK’s gloomy growth and inflation outlook plus the impact of huge increases in public spending look set to weigh on confidence for some time yet.