Why is the Dollar Soaring? US Economy, Rate Expectations, and Geopolitical Risks Explained

From Tech Dominance to Trade Wars: Unpacking the Factors Driving the Greenback’s Strength

Strong Dollar Soars Amidst Global Uncertainty

The US dollar is experiencing a surge, reaching its highest point in nearly two decades. This comes amidst ongoing global instability and economic challenges. The Bloomberg Dollar Spot Index, which tracks the performance of the dollar against a basket of major currencies, has been steadily rising since the pandemic began. This recent increase suggests the dollar’s strength is solidifying at levels exceeding pre-pandemic times.

Meanwhile, emerging market currencies continue to weaken against the dollar. A widely used index by JPMorgan, which measures the performance of emerging market foreign exchange, is approaching its all-time low. This indicates that the value of emerging market currencies is declining compared to the US dollar.

Understanding the Strong Dollar: Are We Witnessing Overvaluation?

The recent surge in the US dollar’s value has sparked debate, leaving many wondering about the underlying causes and whether the dollar is truly overvalued.

Explaining the Rise:

Barclays Bank’s Themos Fiotakis argues that the dollar’s strength can be attributed to several long-term macroeconomic factors that have consistently boosted its fair value:

• Stronger Productivity Growth: The US economy has experienced significant productivity advancements over the past two decades, leading to increased efficiency and output.
• Favorable Terms of Trade: The US has benefited from improved terms of trade, meaning it exports more than it imports, strengthening its overall economic position.
• Higher Investment Returns: The US offers higher returns on capital compared to many other major economies, attracting foreign investment and driving up the dollar’s demand.

A Different Business Model:

Fiotakis highlights the US’s distinct economic approach compared to other major economies. While others embraced globalization, the US prioritized domestic policies that fostered growth within its borders. This strategy, according to Fiotakis, has proven effective in the current economic climate where globalization appears to be receding.

Decoupling and Domestic Focus:

The author argues that the 2008 financial crisis and subsequent developments like the commodities boom marked a turning point in global economic trends. While many countries remain entangled in these dynamics, the US, to some extent, has decoupled and focused on domestic priorities.

Examples of Successful Policies:

The text cites specific policies that have contributed to the US’s economic strength:

• Energy Independence: Investing in energy independence has positioned the US as a net energy exporter, mitigating its vulnerability to global energy price fluctuations.
• Supporting Big Tech: Policies favoring Big Tech have fostered dominant industry giants, attracting significant overseas investment and strengthening the dollar.

Rising Interest Rates: A Boon for the Dollar?

The recent increase in US interest rates has emerged as another factor contributing to the dollar’s strength. With the Federal Reserve unlikely to cut rates anytime soon, the dollar is finding support in this firmer monetary policy stance.

Market Aligned with Fed Expectations:

Current market sentiment aligns closely with the Fed’s projections, suggesting a shared view of a potential 75 basis point decrease in the federal funds rate by year-end. This consensus signals a shift from earlier speculation regarding deeper rate cuts, reflected in the updated Federal Open Market Committee (FOMC) “dot plot.”

Stability Breeds Dollar Strength:

If the FOMC refrains from further revisions in upcoming meetings, it could provide much-needed stability to interest rates, ultimately supporting the dollar’s value.

Delayed Rate Cuts Bolster Dollar Appeal, Says Analyst

Jefferies LLC analyst Brad Bechtel believes the recent shift in expectations regarding interest rates is strengthening the US dollar’s (greenback) outlook. This shift, characterized by later and smaller rate cuts than previously anticipated, helps maintain the dollar’s attractive yield advantage compared to other major global currencies.

Dollar Faces Mixed Signals: Growth Data and Inflation Expectations

The US dollar’s future trajectory remains uncertain amidst conflicting data and expectations.

Market Anticipates Rate Cuts:

Despite ongoing debate, the market currently predicts only rate cuts from the Fed, not increases. Bannockburn Global Forex’s Marc Chandler anticipates upcoming economic data indicating a slowdown, potentially influencing the Fed to cap interest rates.

Technical Indicators Improve for G-10 Currencies:

Meanwhile, technical indicators for several major currencies (G-10) have shown improvement, suggesting a potential upturn in their momentum. While other high-income countries experience subdued growth, the US remains the key focus, particularly considering its performance in late 2023.

US Growth Concerns and Data:

However, concerns linger about the possibility of slowing US growth, which could weaken the dollar. This aligns with expectations held by some market participants.

Inflation Data in Focus:

This week’s release of the Personal Consumption Expenditures (PCE) data for January, a key inflation measure closely monitored by the Fed, will be crucial. As per Bloomberg Economics, analysts anticipate a significant rise in inflation, potentially influencing future US economic policy and impacting the dollar’s value.

PCE Data: A Different Take on Inflation

The upcoming Personal Consumption Expenditures (PCE) data release holds significant weight as it has, until now, presented a more optimistic picture of inflation compared to other widely reported measures. As illustrated in the chart by Win Thin of Brown Brothers Harriman, the PCE has consistently shown a trend of steady disinflation, contrasting with other inflation metrics.

PCE Data Could Spark Dollar Volatility:

The upcoming Personal Consumption Expenditures (PCE) data release carries significant weight for the US dollar. This is because it could impact the market’s perception of US inflation and potentially influence future Fed policy decisions.

Dollar Strength Tied to US Stock Performance, Trade War, and Election Outcome

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The US dollar’s (USD) recent trajectory aligns closely with the performance of US equities. Analysts believe strong faith in US stocks could attract investment and bolster the dollar, while a potential stock market bubble (discussed later) could further strengthen the currency. However, Capital Economics analysts express some doubt:

• US equity outperformance is expected to slightly support the dollar, but Capital Economics forecasts a US stock market bubble within the next few years, and unlike the dot-com bubble, they don’t believe it will significantly propel the dollar.

Trade war concerns also present a potential dollar rally. When countries implement tariffs to gain a competitive advantage, foreign exchange markets typically react by making their currencies stronger. Bloomberg columnist Simon Flint highlights this possibility considering the upcoming US presidential election:

• The US-China trade war historically benefited the dollar. A potential 10% tariff on all US trade under a second Trump term could further strengthen the dollar due to the larger impact such a conflict would have on global growth compared to the US-China trade war.

Electoral uncertainty can often weaken a currency, but in this case, it might have the opposite effect. Strong polling numbers for Donald Trump could potentially lead to a stronger dollar. Until the political landscape clarifies and the Federal Reserve begins cutting rates (both expected in the coming months), the dollar appears poised for further gains.