Why the dollar’s reign won’t last long

THERE IS SOMETHING a little wearying the rough health of the dollar. It seems inevitable, like deceitful politicians and stormy winters. V DXY, the dollar’s value against half a dozen other rich-country currencies has risen nearly 7% since the beginning of the year. The Broad Dollar Index, which measures the dollar against America’s 26 trading partners, has also risen markedly since June. It is hard to imagine what could stop its growth. But it’s worth a try. You may find that the 2022 dollar reversal is more believable than you thought.

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The dollar’s current strength comes from a kind of American exceptionalism. V S&NS The Top 500 Index consistently outperforms the stock markets of other countries. America’s economy has proven to be a reliable source of growth. He emerged from the pandemic stronger than anywhere else. After a brief loss of energy in the summer, he is now showing new strength.

As a consequence, inflation is stubbornly high. Federal Reserve Chairman Jay Powell has already said that the Fed will move faster to stop buying bonds, thereby paving the way for higher interest rates. In other places, things are not so hot. Of China Gdp growth is sluggish. In Europe, the wave of covid-19 infections has led to some restrictions on business activity. While the full implications of the Omicron option are unclear, there is a general feeling that it will prove to be more of an economic obstacle outside America.

One of the currencies that has kept up with the dollar is the yuan. This is because more money flows into China than from it. Huge exports to America have resulted in a huge trade surplus. Portfolio capital is washed away. Foreign investors buy bonds and stocks, which now make up most of their benchmarks. In the meantime, less money is flowing away. Due to the travel ban, Chinese tourists have virtually stopped spending money abroad. However, the risks seem to tilt towards the depreciation of the yuan against the dollar. China is leaning towards easing monetary policy as politicians try to cope with problems in the real estate sector. The fall in reserve requirements this week may even be a hint that Beijing would prefer a weaker yuan.

Put it all together, and the strong dollar argument seems overwhelming. But the situation is unstable. There are good reasons to believe that the dollar will peak and then weaken in the coming months. For this, three conditions must be met. First, the global growth gap needs to be closed. America’s economy has more than recovered. Other countries still have room to catch up. Eventually they will. Too much slowness in Asia is due to the slowdown in China’s economic growth, and not to the lingering effects of the pandemic across the region. Europe never fully opened up. And there is a fiscal stimulus from the outside The EU recovery fund in development. America can still lead. But the race will be closer.

The second condition is lower inflation. Oil prices have already dropped. There are preliminary signs that bottlenecks are improving. Surveys of businesses in manufacturing centers such as Taiwan and Vietnam show that delivery times are increasing. If these events lead to lower headline inflation, says Mansour Mohi-uddin of the Bank of Singapore, it will allow the Fed to move to a less aggressive stance – the third condition for a weakening dollar. It’s hard to be an interest rate dove when inflation is so high. But if it falls during 2022 and the economy slows, the Fed could easily switch to the “jobs” portion of its mandate. By spring or early summer, markets may face more interest rate hikes than the Fed expects.

It is easy to forget about it, but other central banks can also carry out monetary policy. The eurozone economic recovery could easily stir up the hawks at the European Central Bank, says Keith Jukes of Société Générale Bank. Even a hint of a hike in interest rates in the euro area could change the rules of the game for the foreign exchange markets.

For dollar bulls, this may sound a little far-fetched. Much of their enthusiasm stems from high inflation and its implications for interest rates. But this is fraught with danger. According to Stephen Englander of Standard Chartered, another bank, inflation is not the best reason to support the currency. Quite right. If inflation in America is sustained over the medium term, the dollar will clearly not benefit. At the moment, the dollar is the winning currency. But there are a few more ways to lose.

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Learn more from Buttonwood, our Financial Markets Observer:
Have the SPACs been cleared? (December 4, 2021)
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Bailey Gifford and Three Challenges in Fund Management (20 Nov 2021)

This article appeared in the “Finance and Economics” section of the print edition under the headline “The Biggest Dollar.”

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