Whenever I meet clients and investors, the one discussion I always end up having, regardless of market conditions, is on currency markets. There are often strong views expressed about why domestic policy direction or the price of key tradable goods or services is leading to one’s home currency strengthening or weakening.
The discussion we don’t have often enough, though, is the one on the US dollar.
Key anchor for major currencies
While policy and trade are usually the main drivers of major currencies, I often point out that currencies - and their drivers - are relative, not absolute. Therefore, any discussion of policy or external balances of an economy matters, but primarily in relation to the policy or external balances of the economy’s major trade partners, and specifically the US, the world’s biggest economy.
This aspect has been highlighted in 2022, with the dollar gaining significantly against most major currencies year-to-date. While many central banks, especially in Emerging Markets, started to hike interest rates in response to rapid rate hikes by the US Federal Reserve, these often failed to keep up with the pace of the Fed.
In relative terms, this meant the dollar gained on the back of a rising interest rate advantage. Indeed, history illustrates that the direction of the US dollar tends to be the dominant driver of major currencies during periods of a trending US dollar, with most currencies moving in the opposite direction.
This is the first reason why the US dollar matters.
An indicator of global liquidity
The US dollar could also be viewed as an indicator of global liquidity. This, in turn, has a significant impact on major asset classes globally. In an environment of falling liquidity where the USD is scarce, its ‘price’ rises and the dollar strengthens. Conversely, greater liquidity makes the USD less scarce, reducing its ‘price’.
One can see this argument play out when looking at asset class performance in different US Dollar scenarios. Most risky asset classes, including equities and high yield bonds, have done well on average during periods of USD weakness. Performance has been more muted and has often been accompanied by greater dispersion during periods of USD strength.
This is the second reason why the US dollar matters.
Emerging markets
The US Dollar is usually a key driver of Emerging Market assets – and not just currencies, but also equities and bonds. It has been well-documented now that the performance of the US Dollar correlates negatively with EM assets – a rising US Dollar has meant EM assets have underperformed, and vice versa.
Intuitively, there are several reasons why this is the case.
Many Emerging Markets remain sensitive to USD funding costs; a stronger dollar often coincides with rising funding costs, which can be a headwind for EM assets. A stronger dollar (and hence weaker EM currencies) can also directly hurt investment returns for foreign investors, and thus coincide with foreign investor outflows.
This is the third reason why the US dollar matters.
Dollar strength may be running out of steam The US Dollar has strengthened significantly in recent quarters, rising over 25 per cent since mid-2021 as the Fed’s rate hiking cycle offered the currency significant yield support. However, we increasingly believe that this trend is likely to run out of steam in 2023.
The Fed policy has not yet pivoted, and this could lead to a short period of consolidation as sentiment oscillates between optimistic and pessimistic views of how far Fed rates go before they finally pivot.
However, we do believe Fed rates are likely to peak in 2023. The US dollar is also not far from multi-decade valuation highs. Together, these factors are likely to turn the tide.
While the dollar is not the only lens on financial markets, the three reasons cited above on why the dollar matters suggest that a weaker dollar would be positive for major non-dollar currencies, such as the euro and yen, besides improving global liquidity conditions and reviving oversold EM assets.
