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Categories
Currencies
In Fed vs. inflation, the U.S. dollar may be the winner
Jens Søndergaard
Currency Analyst

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

Line chart displays the relative value of the euro, Japanese yen, Chinese renminbi, Canadian dollar and Mexican peso against the U.S. dollar from December 30, 2011, through February 11, 2022. The data is indexed to 100 at the chart’s start date of December 30, 2011. During the first few years, each currency had at least a brief period of strength against the dollar relative to its level at the start date, with the Mexican peso showing the most sustained strength and the Japanese yen the least. By mid 2015, all five currencies were weaker against the dollar and remained so, except for a few brief periods in early 2018 when the Chinese renminbi reached a level stronger than it was at the start date. At the chart’s end date of February 11, 2022, all five currencies were down against the dollar compared with their level at the start date. The renminbi was down the least, followed by the euro, Canadian dollar, Mexican peso and Japanese yen.

Source: Bloomberg. As of February 11, 2022. All data indexed to 100 as of December 30, 2011.

Fed’s hawkish stance should be supportive


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

Line chart displays the levels of the U.S. consumer price index and median inflation of a basket of other countries — Canada, China, Japan, Mexico, plus the euro area — from January 1, 2011, to January 1, 2022. For most of that time, U.S. inflation exceeded the median of the other countries. In early 2021, U.S. inflation began to rise sharply, significantly widening the gap.

Sources: Capital Group; U.S. Bureau of Labor Statistics; National Institute of Statistics and Geography (Mexico); National Bureau of Statistics of China; Statistics Canada; Japanese Statistics Bureau, Ministry of Internal Affairs & Communications; Eurostat. As of January 1, 2022.
Note: Inflation measure is core inflation. Non-U.S. group includes Canada, China, Japan, Mexico and the euro area.

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

Line chart displays the differential between U.S. real interest rates and real rates in Germany, Japan and the United Kingdom from January 1, 2008, to February 14, 2022. The differential was positive for most of that time, indicating that U.S. real rates were higher than those in the other countries. It peaked on November 12, 2018, then fell steadily until turning negative for a few days in late August and early September 2020. It rebounded from there, and in late January hit a level last seen in March 2020. The differential hit its most negative point on October 4, 2012, when real rates were lower than those in the other countries.

Sources: Capital Group, Macrobond. As of February 14, 2022.
Note: Based on the yield of 10-year U.S. Treasury Inflation-Protected Securities (TIPS) relative to the corresponding yields of inflation-indexed bonds in Germany, Japan and the United Kingdom. A real rate differential is the difference between two interest rates that have both been adjusted for inflation.

Dollar could remain overvalued


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:

  • Global growth forecasts for 2022 look optimistic. In my view, the global consensus for economic growth this year has not fully factored in the impact of slowing growth in China and the most recent escalation of the conflict between Russia and Ukraine. Paired with rising inflation around the world, that suggests a coming round of downward revisions to growth expectations. Typically, that tends to benefit safe-haven currencies such as the U.S. dollar and Japanese yen.
  • Growth tailwinds are stronger in the U.S. than elsewhere. The U.S. continues to see a stronger post-COVID-19 recovery than the rest of the world, buoyed by a strong U.S. consumer. Trillions of dollars in fiscal and monetary stimulus over the past two years have left consumers flush and household balance sheets in the best shape in decades.
  • The differential in global real interest rates continues to support the U.S. dollar. The appeal of higher real rates in the U.S. should attract additional foreign capital flows, which would help finance the U.S. current-account deficit and keep the dollar overvalued. 
  • A weaker Chinese economy could weigh on emerging markets currencies. These currencies tend to be highly procyclical, so a slowdown in China that drags down global growth could be challenging for them relative to the dollar. At the same time, most emerging markets currencies weakened significantly in 2021, leaving them with cheaper valuations. Some of these currencies enjoyed a bounce in early 2022, but it remains to be seen whether that is the start of an enduring trend. If it is, currency effects could be positive for returns on emerging markets debt.

U.S. dollar remains overvalued

Line chart displays the extent to which the U.S. dollar was overvalued or undervalued from January 31, 1996, to February 10, 2022. At the beginning of the period, the dollar was undervalued. Broadly speaking, it had a period of overvaluation from 1998 to 2004, a period of undervaluation from 2007 to 2014 and another period of overvaluation from 2015 through the present.

Sources: Capital Group, J.P. Morgan. As of February 10, 2022.
Note: Chart displays the percentage by which the U.S. dollar’s trade-weighted nominal exchange rate is greater than or less than its trade-weighted nominal fair value.

Bottom line


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. 



Jens Søndergaard is a currency analyst with 16 years of industry experience (as of 12/31/21). He holds a PhD in economics and a master’s degree in foreign service from Georgetown University.


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