Markets & Economy
Will surging inflation in the United States finally upend a decade-long bull run for the U.S. dollar? It’s a question I’ve been getting from many of my colleagues and several of our clients. My answer remains no.
Even though traditional analysis would suggest that higher inflation is typically a long-run currency headwind, I still think it’s too early to call an end to the U.S. dollar bull run. Higher real interest rates that continue to draw foreign capital flows to the U.S., as well as solid economic growth and the persistence of the dollar’s status as a safe-haven currency in periods of geopolitical stress should continue to support a stronger dollar outlook.
U.S. dollar has outpaced currencies of major trading partners
To assess where the U.S. dollar is headed, it’s important to consider how aggressive different central banks will be in their efforts to tame current high inflation rates. The Federal Reserve is signaling a series of rate hikes beginning in March and discussing ways to shrink its balance sheet. Futures markets are pricing in a federal funds rate of 1.25%–1.50% by year-end, up from 0%–0.25% today. But the market is not expecting much further Fed tightening in 2023 and 2024. I think the Fed is likely to tighten monetary policy in 2023 by more than is currently priced in, which would keep the bullish dollar narrative intact despite elevated inflation in the U.S.
U.S. inflation has outpaced other major economies
In Europe, monetary policy remains looser. The European Central Bank (ECB) recently joined the hawkish fray by declining to rule out a rate hike this year after euro area inflation reached a record 5.1% in January, but its key deposit rate remains at –0.50% and it indicated that it would start to raise rates only after ending asset purchases.
Still, the ECB’s surprise pivot to a more hawkish stance prompted several market analysts to call for a resurgence of the euro. But I think the euro must overcome high hurdles to gain meaningfully against the dollar and other major currencies. To get substantial euro strength, we would need to see sustained economic growth in the euro area, including Spain and Italy in particular. Such a scenario would also involve sharply higher real yields on German government bonds sufficient to reverse capital outflows from the euro area. I am skeptical that this is imminent.
Meanwhile, among other major central banks, both the United Kingdom and New Zealand have lifted rates several times in recent months. The Bank of England (BOE) raised its key bank rate to 0.50% from 0.10%, and an inflation reading of 5.5% in January — a 30-year high — fed speculation of another BOE rate hike soon. Policymakers in several emerging markets, particularly in Latin America, have been proactively tightening monetary policy for even longer, a notable shift from prior inflationary episodes when they have followed the lead of central banks in advanced economies.
In contrast, the two major Asian central banks are leaning more dovish as inflationary pressures are less pronounced in the region. Last month, the Bank of Japan nudged up its inflation forecast just 20 basis points to 1.1% for the coming fiscal year — its first increase since 2014 — while maintaining its negative target rate. The People’s Bank of China has made a small rate cut and taken other measures to ease monetary conditions amid a slowdown in economic growth and stress in the property sector.
While these moves could shake up the global rates picture, the U.S. dollar remains in a position of strength. As the Fed prepares to tighten, real rates in the U.S. are already well above those in most other advanced economies. Short-term nominal rates have soared, with the two-year U.S. Treasury yield more than doubling so far in 2022. So long as savers and investors in countries like Germany and Japan can continue to earn high rates in the U.S., the dollar should continue to hold up.
U.S. real rate differential continues to support the dollar
No doubt, the dollar has been overvalued for many years — since 2015, by one measure. While that should correct at some point, I don’t see a catalyst for a near-term drop in the dollar. For the foreseeable future, several cyclical factors are likely to keep it stronger for longer:
U.S. dollar remains overvalued
The U.S. dollar has enjoyed a structural bull run for the past decade and it appears overvalued by many metrics. At some point, the currency will shift into a bear cycle. But given the Fed’s intention to wage a campaign of tighter monetary policy to tackle inflation, it is unlikely that a dollar downturn will arrive anytime soon. The dollar’s path will depend in part on how aggressively other central banks fight their own inflation battles.
The question for all central banks will be how to control inflation without short-circuiting economic growth. If they manage to move in lockstep, they could produce a “Goldilocks” scenario where inflation declines in a relatively swift and orderly fashion without pulling the rug out from under the global economy. Declining inflation would leave real rates at more elevated levels. This would argue for investors to be more globally diversified, with broad exposure to a basket of non-U.S. currencies. This positioning would also serve as a possible hedge for the day when the dollar cycle turns bearish.
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