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Why the dollar’s ascendancy won’t last

All it takes is a slowdown in America, lower inflation and a Fed pivot THERE IS SOMETHING slightly tedious about the dollar’s rude health. 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 by almost 7% since the start of the year. The broad dollar index, which measures the dollar against 26 of America’s trading partners, has also risen markedly since June. It is difficult to imagine what might check its rise. But it is still worth trying. You may find that the case for a reversal of the dollar in 2022 is more plausible than you had thought. The dollar’s current strength is tied to American exceptionalism of a sort. The S&P 500 index of leading shares consistently outperforms the stockmarkets of other countries. America’s economy has proved to be a reliable source of growth. It has emerged from the pandemic more strongly than just about anywhere else. After a brief loss of energy in the summer it is now showing renewed vigour. As a consequence, inflation is stubbornly high. The chairman of the Federal Reserve, Jay Powell, has already said that the Fed will move faster towards ending its bond purchases, thus paving the way for interest-rate increases. Elsewhere things are running less hot. China’s GDP growth is sluggish. In Europe a wave of covid-19 infections has led to some restrictions on business activities. And while the full implications of the Omicron variant are not certain, there is a general feeling it will prove to be more of an economic headwind outside America. One currency that has kept up with the dollar is the yuan. This is because more money is flowing into China than out of it. Bumper exports to America have contributed to a huge trade surplus. Portfolio capital is washing in. Foreign investors are loading up on bonds and stocks, which are now a bigger part of their benchmarks. Meanwhile less money is leaking out. Spending abroad by Chinese tourists has all but vanished, as a consequence of travel bans. Still, the risks seem tilted towards a fall in the yuan against the dollar. China is leaning towards a looser monetary setting, as policymakers grapple with distress in the property sector. This week’s reduction in reserve requirements might even be a hint that Beijing would prefer a weaker yuan. Put this all together, and the argument for a strong dollar looks watertight. But the situation is fluid. There is a decent case that the dollar will peak in the coming months and then weaken. For that to happen, three conditions need to be fulfilled. First, the global growth gap must narrow. America’s economy has more than recovered. Other countries still have ground to make up. They will eventually do so. Too much of the sluggishness of Asia is put down to China’s slowdown and not enough to the lingering effects of the pandemic across the region. Europe has never quite reopened fully. And there is fiscal stimulus from the EU recovery fund in the pipeline. America may still lead the pack. But the race will be closer. A second condition is lower inflation. Oil prices have fallen already. There are tentative signs that bottlenecks are easing. Business surveys in goods-producing hubs, such as Taiwan and Vietnam, show a pickup in delivery times. If these developments translate into lower headline inflation, says Mansoor Mohi-uddin of the Bank of Singapore, it will allow the Fed to pivot towards a less hawkish stance—a third condition for a weaker dollar. It is hard to be an interest-rate dove when inflation is so high. But if it falls back during 2022, and the economy slows, the Fed’s focus could easily tip back to the “jobs” part of its mandate. By the spring or early summer, markets may find themselves pricing in more interest-rate rises than the Fed is minded to deliver. It is easy to forget, but other central banks get to do monetary policy, too. A recovering euro-zone economy might easily stir the hawks at the European Central Bank, says Kit Juckes of Société Générale, a bank. Even the hint of an interest-rate rise in the euro zone could be a game-changer for currency markets. For dollar bulls, this might all sound a bit far-fetched. A lot of their enthusiasm is tied to high inflation and its implications for interest rates. But this carries dangers. Inflation is not a high-quality reason for backing a currency, says Steven Englander of Standard Chartered, another bank. Quite so. If inflation in America proves stubborn in the medium term, that is not obviously good for the dollar either. For now, the greenback is a winning currency. But there are still a few ways it could lose. Read more from Buttonwood, our columnist on financial markets: Have SPACs been cleaned up? (Dec 4th 2021) Why the bond market has become jumpier (Nov 27th 2021) Baillie Gifford and the three quandaries of fund management (Nov 20th 2021)

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