Why the rise of the dollar will not last

THERE IS SOMETHING slightly boring about the gross health of the dollar. It seems as inevitable as lying politicians and stormy winters. the DXY, a gauge of the dollar against half a dozen other rich world currencies, is up nearly 7% year-to-date. The broad dollar index, which measures the dollar against 26 of the United States’ trading partners, has also risen sharply since June. It’s hard to imagine what could hold back his rise. But it’s still worth a try. You may find that the case for a dollar reversal in 2022 is more plausible than you think.

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The current strength of the dollar is linked to American exceptionalism in a way. the S&P The 500 index of leading stocks consistently outperforms the stock markets of other countries. The US economy has proven to be a reliable source of growth. He came out of the pandemic more strongly than anywhere else. After a brief loss of energy in summer, it now shows new vigor.

As a result, inflation is stubbornly high. Federal Reserve Chairman Jay Powell has previously said the Fed will speed up ending its bond purchases, paving the way for interest rate hikes. Elsewhere, things heat up less. from China GDP growth is slow. In Europe, a wave of covid-19 infections has resulted in some restrictions on business activities. And while the full implications of the Omicron variant are not certain, there is a general feeling that it will be more of an economic headwind outside of America.

One currency that has followed the dollar is the yuan. This is because more money goes into China than outside. The exceptional exports to America contributed to a huge trade surplus. Portfolio capital is pouring in. Foreign investors feed on bonds and stocks, which now form a larger portion of their benchmarks. During this time, less money escapes. Spending abroad by Chinese tourists has all but disappeared, due to travel bans. Still, the risks appear to be on a decline in the yuan against the dollar. China is leaning towards a looser monetary framework, as policymakers grapple with distress in the real estate sector. The reduction in reserve requirements this week could even be a hint that Beijing would prefer a weaker yuan.

Put it all together, and the argument for a strong dollar seems unshakeable. But the situation is fluid. There are good reasons the dollar will peak in the coming months and then weaken. For this, three conditions must be met. First, the global growth gap must narrow. The US economy has more than recovered. Other countries still have some catching up to do. They will eventually do it. Too much of Asia’s slowness is attributed to the slowdown in China and not enough to the lingering effects of the pandemic in the region. Europe has never fully reopened. And there is a fiscal stimulus from the EU stimulus fund in preparation. America can still lead the pack. But the race will be closer.

A second condition is lower inflation. Oil prices have already fallen. There are signs that the bottlenecks are easing. Business surveys in goods-producing hubs, such as Taiwan and Vietnam, show an upturn in delivery times. If these developments translate into lower headline inflation, according to Mansoor Mohi-uddin of the Bank of Singapore, this will allow the Fed to shift to a less hawkish stance, a third condition for a weaker dollar. It’s hard to be an interest rate dove when inflation is so high. But if it falls back in 2022 and the economy slows, the Fed’s attention could easily shift to the “jobs” portion of its mandate. By the spring or early summer, markets could find themselves forecasting more interest rate hikes than the Fed is willing to offer.

It’s easy to forget, but other central banks can also do monetary policy. A recovery in the eurozone economy could easily fan the hawks of the European Central Bank, according to Kit Juckes of Société Générale, a bank. Even the suspicion of an interest rate hike in the eurozone could be a game-changer for currency markets.

To dollar bulls, this may all seem a bit far-fetched. Much of their enthusiasm relates to high inflation and its implications for interest rates. But that carries dangers. Inflation is not a great reason to support a currency, says Steven Englander of Standard Chartered, another bank. Absolutely. If inflation in America proves to be stubborn in the medium term, it is obviously not good for the dollar either. For now, the greenback is a winning currency. But there are still a few ways he could lose.

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Learn more about Buttonwood, our financial markets columnist:
Have the PSPCs been cleaned? (December 4, 2021)
Why the bond market has become more nervous (November 27, 2021)
Baillie Gifford and the Three Dilemmas of Fund Management (Nov 20, 2021)

This article appeared in the Finance & economics section of the print edition under the title “Top dollar”

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