The U.S. dollar is again the darling of investors, but this time, for reasons that go beyond America’s borders. China’s economic deceleration and Covid lockdowns, Russia’s move to use its natural-gas exports to retaliate against Ukraine’s allies, and Japan’s continued commitment to record-low interest rates have all driven other currencies to the weakest against the dollar in years.
The scope of that geopolitical turmoil is reviving the dollar’s status as a haven, extending gains seen earlier this year as traders shifted to the U.S. to seize on rising interest rates from the Federal Reserve. A Bloomberg gauge of the greenback pushed through to the strongest level since 2002 and recorded its biggest yearly gain (+8%) since 2010 versus a basket of 10 major currencies!
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The dollar’s rally, even in the face of surging U.S. inflation, a shaky stock market, significant ructions in cryptocurrencies and speculation that rate hikes could set off a recession, seems to track the “dollar smile” theory. That model predicts that the dollar will advance under two opposing scenarios: when risk aversion fuels demand for the safest assets such as the Treasuries, or when U.S. growth outperforms the rest of the world. It is the haven side of the equation that is driving it now! Markets are worried and looking for safe havens.
The dollar is also supported by a jump in bond yields that has pushed them closer toward the rate of expected inflation. The 10-year Treasury’s yield (around 3%) is now, for the first time since the pandemic, above the inflation expected in ten years by the bond market (2.7%). It is the best possible combination for the dollar – a rise in U.S. yields at the same time growth vulnerability has increased outside the U.S.
As a consequence, many of the dollar’s global counterparts are falling to levels that haven’t been seen in years and currency swings have hit the highest since the Covid outbreak first roiled markets. The pound slid to a fresh 2020 low, the yen dropped to the weakest since 2002, the euro hit a five-year low, the Swiss franc weakened to hit parity with the dollar for the first time since 2019, while India’s rupee slumped to a record low. Developing-nation currencies are also being pummeled due to the threat of funds being pulled from their stock and bond markets as U.S. yields rise. “Fragile” emerging economies with current-account deficits including Turkey and nations in Africa are particularly vulnerable. A stronger dollar encourages capital outflows from emerging markets and tightens their financial conditions.