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The dollar’s strength spreads from emerging to developed economies

A bear market in global stocks and fixed-income markets has left investors with little choice but to increase their cash allocations and especially in US dollar.

With global equities already down €9 trillion in 2022, the greenback’s inverse relationship to risk assets makes it the only game in town on the currency market. In a world where central banks are aggressively hiking rates (bad for fixed income) in order to tighten financial conditions (bad for equities), then one of the only place to hide is in USD cash.

As a result, Developed economies are taking a hit from the dollar’s appreciation to multi-decade highs in ways that were once more familiar to their emerging market (EM) peers. Fueled by the Federal Reserve’s most aggressive tightening cycle in more than a generation, the stronger greenback is pushing rival currencies lower, driving up the cost of imported goods, feeding inflation in other economies and constricting financial conditions. While global ripples from Fed tightening aren’t new - a stronger dollar generally comes with higher short and long-term interest rates in the U.S., or with stress in global markets and a flight to the dollar’s perceived safety -, this is the first episode in recent years where serious dollar strength has been more notable against developed-nation currencies as a group than versus emerging economies. The Fed’s trade-weighted dollar index versus advanced economies has soared 10.5% this year to the strongest since 2002, while the EM measure is up a more modest 4.5% and remains well below its peak from the 2020 pandemic. 

US currenccy surges much further against developed peers on Fed hikes

Although tighter financial conditions cause developed economies everywhere to slow, the strength of the dollar is ratcheting up pressure on other central banks to raise interest rates just as an energy crisis and spiraling consumer prices hobble Europe’s economies, and increases in borrowing costs cool housing markets in Australia, Canada and New Zealand. Yet their ability to influence the dollar’s strength is limited, meaning there is little prospect for near-term relief. That is because the dollar strength - its value has increased this year by more than 13% against the currencies of the ten most industrialized countries - not only reflects an expectation about the federal funds rate hikes this year – and thus higher demand for US fixed-income assets - but also reflects global recessionary risks arising from the greater-than-previously-expected policy rate hikes around the world. That conundrum has been illustrated in September as the European Central Bank (ECB) decided a record 0.75% rate increase while it contends with record inflation and the euro below parity with the dollar. The Bank of Canada has raise by the same amount to 3.25% and the Reserve Bank of Australia just delivered another half-percentage point rate hike to 2.35%. In the UK - which is already in a recession, according to a business lobby group - the Bank of England (BoE) may tighten further (its main policy rate is set at 1.75%) as it confronts a loss of faith from investors that has pushed the pound to the brink of its lowest since 1985. And the yen’s drop to a quarter-century low is making it tougher by the day for Bank of Japan (BoJ) Governor Haruhiko Kuroda to stick to his line that massive monetary support is still needed (the Japanese policy rate is -0.10%), even in the face of rising prices. 

Performance of main currencies versus a basket of 10 major currencies (base 100 = end 2021)

With the Fed not done hiking yet, relief on the currency front for the world’s central bankers may only come once US counterparts get consumer prices under control. Since it became clear the Fed would switch to tightening mode about a year ago, developed-market currencies have struggled at least as much as their emerging-nation counterparts. Across 31 main major exchange rates, four developed ones were among the 10 biggest losers and only one, the Canadian dollar, among the 10 best performers.

  • For central banks such as the ECB, whose currency is the most-traded with the dollar, the current energy crisis has provided its policy makers with a particularly sharp reminder of the euro’s role as a channel for inflation - not least because of the greenback’s use in denominating global commodity prices. “I would argue that, in this particular situation of an energy-supply shock, the exchange rate matters more,” ECB Executive Board member Isabel Schnabel told last month when asked about previous research suggesting the pass-through to inflation has lessened. Import prices are rising, adding to the year-over-year change in producer prices, which reached 37% in Germany in July, exceeding estimates and touching the highest level in data going back to 1977. Although a weaker euro makes exports from the Euro-Area more attractive and competitive, higher import prices might hurt company margins or, if producers are able to use pricing power, will feed through to consumers. That would ratchet up pressure on the ECB to fight inflation more aggressively, even if the bank doesn’t have a target exchange rate for the euro. As a consequence, the Stoxx Europe 600’s valuation has dropped to the lowest level since 2005 against the S&P 500, trading at a discount of more than 30% to US stocks. While both regions are suffering from the impact of soaring inflation and hawkish central banks, Europe faces a myriad other headwinds including a weaker currency, surging power prices and political uncertainty in Italy and the UK. That is why we keep our overweight exposure on US stocks versus the European ones.

Euro, below parity with the dollar, is in decline since the financial crisis

  • Japan, whose currency is the second-most traded with the dollar, is feeling the brunt too. Having surged past the 143 level against the US dollar, the currency is not far from the 146 mark that prompted joint action with the US in 1998 to prop it up. It also raises the odds of inflation topping 3% - well above Kuroda’s 2% target. While the BoJ chief insists that a recent supply-driven increase in consumer prices won’t last, households and businesses are becoming more and more restless as the yen’s dive turbo-charges soaring energy and import costs. 
  • The bigger concern for many countries could be that local rate hikes may do little to slam the brakes on their nose-diving currencies because their economies look more fragile than the US. The British pound is on the verge of dropping past its March 2020 low, despite swaps traders pricing for the BoE to out-hike the Fed, with bets showing the UK’s benchmark will top 4.25% within six months, exceeding the 4% in the US by then.

One possibility for relief would be a slowdown in the US economy that takes the steam out of the Fed’s pace of tightening, and by extension causes the dollar to weaken. For now, the Fed has signaled relief may be some ways off, with the need to keep policy tight for some time to quell inflation. The issue will thus become acute for developed-economy policy makers if the dollar keeps overshooting. So central banks will probably keep increasing interest rates this year even if domestic asset markets are plunging and growth is faltering.