The Dollar U-Turn

 

The Million Dollar Song

Calby, 2021

Star Alignment

Safe haven

Thanks to its world reserve currency status and high liquidity, the USD is the investor’s undisputed safe haven currency of choice. Its safe haven status has been demonstrated many times in the past during various economic crises, the latest being Covid 19, where the US Dollar index jumped +8% in just over a week. Following the unprecedented monetary and fiscal stimulus that ensued, the USD retraced, as growth-oriented assets recovered significantly, reducing the greenback’s appeal and the need for hedges. The appearance of the delta variant in late 2020 also coincides with the lows made in the US Dollar index; as uncertainty increased again, so did the demand for US dollars. As fears shifted away from the delta variant and towards the central banks, market stress remained high and sentiment weakened, further supporting the dollar and marking the beginning of the bull market we are experiencing to this day.

Figure 1: The US dollar reacts well to market stress episodes

Source: Bloomberg, Unigestion as of 05.05.2022

With the high uncertainty persisting from both central bank normalisation and the ongoing Ukrainian conflict, USD demand will likely remain firm for now.

Central banks

Central banks are indeed a very important component in driving FX price action and particularly the US Federal Reserve (Fed) for obvious reasons, given the influence it has on the world’s reserve currency. As the Fed turned increasingly hawkish to tackle inflation head on, the interest rate differential unsurprisingly became a natural tail wind for the USD.

Figure 2: Positive carry is an important tailwind for the USD

Source: Bloomberg, Unigestion as of 05.05.2022

Although the Fed was among the early major G10 central banks to turn hawkish, there was always the risk that the others would converge towards that hawkish stance, potentially becoming a headwind for the long USD trade. In other words, peak Fed hawkishness had been reached and priced in, whereas other central banks were still catching up, leaving room for their currencies to appreciate. However, this argument suffered a major setback when the war in Ukraine started. Indeed, Europe, which makes up the bulk of G10 currencies, is much more at risk from the conflict from a macro perspective than the US, given its openness and dependence on energy imports from Russia and the resulting price shock. This means that the US effectively has more room to tighten monetary policy compared to Europe, keeping the interest differential wider and thus favouring the US dollar.

Interestingly, looking at Europe and the ECB, whose primary mandate is to achieve price stability through low inflation (+2% over the medium term), the overall message continues to be dovish, especially when compared to its neighbours. Although some members are now acknowledging that the ECB is falling behind the curve on inflation, a majority seem to favour a gradual approach, given the uncertainty on growth caused by the ongoing Ukrainian invasion. Although the ECB will start to scale back its bond purchases, in addition to some rate hikes now priced in by the market for this year, is should normalise at a slower pace than other western central banks. The Fed on the other hand, which has a “dual” mandate of achieving stable prices and maximum sustainable employment, is currently obsessed with tackling inflation. The message from this week’s FOMC meeting was clear: nothing will derail “fighting inflation” as a top priority for the Fed. This hawkish bias implies tighter financial conditions, which will prove a challenge for most assets classes and should keep USD demand firm, both from a safe haven and an interest rate differential perspective.

Macro

An important driver behind any foreign exchange move is the underlying macroeconomic environment. A simplified notion is that a strong economy will see capital inflows, which then naturally strengthens the underlying currency. There was a strong case early 2022 that the EUR would benefit from capital flowing from US to European indices, which have a “Value” tilt and tend to perform well in a rising rates environment. However, the Ukrainian conflict has lifted the odds of a European recession while US macro momentum remains firm for now. From a macro perspective, the case of a stronger USD therefore holds, as can be seen from the recent divergence between our EU and US Growth Nowcasters.

Inflation remains a concern for most major economies today and here again the notion of foreign exchange is pertinent, as a weaker currency is inflationary in itself (imports become more expensive). This has been a concern, notably for Poland, which was quick to raise rates in an attempt to limit the fall in its currency following the Russian invasion of Ukraine. ECB board member Villeroy also said last week: “a too weak EUR would go against the ECB inflation target”.

Central banks are in a complex situation, having to balance the threat of very high inflation without killing growth, which they tried to stimulate for years. This normalisation process brings large divergences that will continue to widen and undoubtedly affect currencies. Some countries will also be keen to use FX as a policy tool, given its macro implications.

Figure 3: Divergence between the US and EU Growth Nowcaster

Source: Bloomberg, Unigestion as of 05.05.2022

Emerging markets started an aggressive rate hike cycle in early 2021. For example, Brazil hiked its Selic rate by 10.75% from record low levels in late 2020 / early 2021. This explains why some EM Currencies such as the BRL have outperformed the USD significantly year-to-date. Here again, dispersions are large and a majority of FX pairs are down against the US Dollar on a year-to-date basis.

Conclusion

The current market environment remains challenging as uncertainty continues to dominate. Central banks are focused on tackling inflation, which has undermined asset valuations and negatively affected sentiment. Tighter financial conditions mean most assets are likely to continue falling, or at least until short-term and long-term inflation expectations converge towards central bank targets. However, dispersions remain and generally speaking, the current environment should continue to favour the USD. It is worth noting that positioning is increasingly tilting towards the long USD trade and that, after making fresh year-to-date highs not seen since 1990 and March 2020, the US Dollar Index’s momentum is bound to slow.

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