The US dollar is on the rise. Even as the US economy shows signs of slowing, the greenback has surged against major currencies from Europe’s 19-member euro to the Chinese renminbi. An index of the dollar against other major currencies is trading around a two-decade high.
Investment tends to flow into higher-yielding currencies, and the greenback has rallied in part because the Federal Reserve is raising interest rates more aggressively than some other central banks to curb inflation, according to Kamakshya Trivedi, head of global foreign exchange, interest Interest rates and emerging markets. The dollar, seen as a haven from turmoil, has also risen amid growing concerns that the energy price shock will stall economic growth in many parts of the world.
But Trivedi says there are signs the dollar is rallying in its “later innings” as it nears extreme levels against currencies like the Japanese yen or the British pound, which has traded at its weakest against the greenback since Margaret Thatcher Britain was Prime Minister. We spoke to Trivedi about the risks to emerging market currencies from the dollar rally and its prospects for the world’s reserve currency.
What are some of the key factors underpinning the US Dollar’s strength against major currencies?
First, there are relative political differences between the US and other major regions of the world. The US economy appears to be on firmer footing, inflation appears to be more broadly based and the Federal Reserve appears more unrestrained than many other parts of the world in raising interest rates and tightening monetary policy.
To give you an example, the European Central Bank has also been running its monetary policy quite aggressively, but it needs to keep a half-eye on whether policy tightening raises sovereign bond concerns and whether it is causing financial fragmentation. Across Europe, concern about the energy shock is paramount. In contrast, the Fed has been able to be more aggressive and proactive in tightening monetary policy.
The dollar is also special, and that is the second part. It tends to perform well when there are concerns about a global recession and risk-off sentiment prevails in the markets. The dollar is a “safe haven” and you tend to see reflows into the dollar which also support the currency.
For most of that year, one or both of these forces were deployed. Much of the dollar’s strength in the first quarter was due to the Fed simply being more aggressive and the market pricing this in relative to others. The second quarter had a little more of that recession-like flair, with the dollar performing well against a broad range of developed and emerging market currencies as recession concerns reigned supreme. As we move through the third quarter, it’s sort of reverted back a bit to the flavor of the first quarter where the Fed’s steady and big moves once again appear to be supporting the dollar against the major currencies.
Is the Dollar Rally a Concern for Developed Market Currencies? For example, there has been speculation in the media of intervention in the Japanese yen and an emerging-market-style crisis in the British pound.
There has been much discussion about these issues. Let me start with the UK: the first thing I would like to acknowledge is that the situation is definitely challenging. There has been a significant shock in terms of pressure on energy prices and no government policy can fully offset this. But I think we are a long way from the EM-style balance of payments crisis in the UK. These things usually happen when you have a fixed exchange rate system and a lot of foreign debt denominated in dollars or foreign currency. These are not characteristics of the UK
My impression is that we have just had a summer in which there has been some uncertainty about government formation and government policy, and as a result there has been some reluctance on the part of policy makers.
Now that you have some clarity on the fiscal response, there is a chance that the Bank of England will be more forceful as well. That should put some of those crisis-ridden stories to rest. But there is no question that the energy shock is weighing on the UK’s external balance and the weaker pound itself is an adjustment mechanism for this external shock. So some level of weakness we’ve seen seems justified, but I caution against extrapolating that too far and thinking of an EM crisis.
In some ways, the yen is even more interesting. Yes, the yen has weakened sharply against the dollar, at levels close to historically weak levels for the currency. But again, it’s important to remember that a weaker yen is a direct result of policies implemented by the Bank of Japan, and that’s meant to weaken the yen at times like these. Yield curve control, whereby the Bank of Japan fixes its yields even as yields and interest rates rise around the world, is intended to create yen weakness and thereby fuel the domestic inflationary process.
It is natural for market participants to look to these stretched levels, whether it be in the pound or the yen, and worry about a reaction and whether these moves will be halted. But it’s important to step back and think about what’s causing it. While policy may change, we believe the weaker yen and sterling are a direct result of the shocks and policies that have played out.
And what about emerging markets? Is there a risk that the strength of the dollar will cause stress in any of these currencies?
That’s a place where I think the concerns are more genuine. Certainly there are emerging markets where some of these characteristics are in place – fixed exchange rates, debt denominated in foreign currencies – and where, due to dollar strength and higher US interest rates over the past few months or so, there have already been significant problems.
There are a number of these emerging markets that have been pushed into what I would call corner solutions. They have either been forced to default on their foreign currency debt, and Sri Lanka is an example, or, like Pakistan and Egypt, they are involved with the International Monetary Fund. Foreign currency credit spreads are also trading at very worrying levels in several other countries.
For this group of countries, which I would call emerging markets, these concerns are real, but in many cases they are already reflected either in prices or even in their exposure to the IMF.
Much of the weakness in broader emerging markets — say the South African rand or Indian rupee against the dollar — reflects challenges not dissimilar qualitatively to many DMs: interest rate hikes, which have struggled to outperform the US Federal Reserve, for example, and Energy price shocks that have exacerbated current account deficits. The challenge for these emerging markets is that weaker currencies complicate the already difficult task of controlling inflation and inflation expectations.
How far are we in this cycle in terms of dollar strength? Has the peak passed?
The dollar has been strengthening for some time. By some measures of the broad dollar, it’s up about 15% this year, up 20% since early 2021. On a valuation basis, the dollar looks overvalued. Perhaps not quite as overvalued as previous highs, but not far from those levels either. And if you look at individual currency pairs as I have described, against the yen or against the pound, you are at levels that seem relatively extreme.
Putting all of this together, I think it’s probably fair to say that we’re in the later innings of this cycle of dollar strength. We still believe the dollar has a little more room to strengthen, partly due to the factors I mentioned earlier. We still believe they are in the game.
We assume that the US economy will continue to perform slightly better than other major economies such as the euro zone and China. As a result, we also expect the Fed to remain at the forefront of its tightening process, which should continue to support the dollar from these levels. But I think it’s fair to say that we are late in this cycle of dollar strength.
Is Dollar Strength A Headwind Or Tailwind For US Economy?
The bottom line is that dollar strength is a headwind for the entire US economy. A stronger dollar is often part of a mix of tighter financial conditions that policymakers focus on when trying to slow the economy.
But it is obviously also an important factor driving the inflationary process. A stronger dollar translates into lower domestic prices for imported goods, and I would argue that at this point where inflation seems way too high and way out of whack compared to the target, US policymakers are likely on looking at the stronger dollar and are quite happy with the help they are getting on the inflation front rather than the fact that there is some net headwind to activity.
Inflation is the bigger priority right now, so I don’t think it’s unwelcome, while it might not be big, whatever you can get from a stronger dollar on domestic inflation metrics.
Which other currency pairs are particularly important at the moment?
The Euro-Dollar is always an important currency pair to watch. It is currently at a key level, hovering around parity against the dollar. Much of what happens to the broad dollar will be highly correlated to what happens to the euro and the eurozone outlook. Our economists are still fairly optimistic and expect a recession in the Eurozone and accordingly we expect the Euro to trade below par for the next three months or so.
The Chinese renminbi is another spot where we expect further weakness and stronger dollar strength over the next two to three months. Again, at a very basic level, it reflects the fact that China’s economy is also struggling somewhat, both from back-to-back local lockdowns due to the zero-Covid policy and ongoing problems in the domestic real estate sector.
The difference in relative policy stances is perhaps clearer in China than in most other countries: you have a Fed, which is raising rates even as the US economy is slowing, and then you have the People’s Bank of China, which is raising rates given the kind of struggles the economy is facing. The upshot of these two things is that we expect the dollar-renminbi cross to continue moving higher and the renminbi to continue weakening.