A key story of 2022 is the steady rise of the US Dollar. With all the uncertainty in the world right now, one point of stability has been the resilience of the greenback, which has sharply outperformed its global currency peers.
Several factors are behind the Dollar’s rise: Its status as a safe haven asset during times of geopolitical uncertainty and market volatility; the US economy’s relative strength versus global peers; and one of the swiftest rate-hike cycles in the Fed’s history.
Overbought technical conditions suggest the stage is set for a reversal at a time when the Dollar is at its most overvalued in 20 years, relative to other major currencies. However, the path of the Dollar will continue to be influenced by short-term developments such as shifts in risk sentiment and in Fed policy expectations. In turn, any substantial shift in the path of the Dollar will affect global financial conditions and carry big implications for emerging markets, making it an important indicator for investors to monitor.
On a year-to-date basis, the US Dollar Index (DXY) has risen an impressive 11%, after being up almost 20% at its peak in September compared to a basket of six other major currencies including the Euro, Yen and Sterling. The Dollar’s reputation as a safe haven in times of heightened economic and geopolitical uncertainty has been a major factor. The Dollar tends to perform well when there are concerns of global recession and when a risk-off mood prevails in markets.
A Strong Dollar Is Contractionary for the Global Economy
The invasion of Ukraine triggered an initial appreciation of the US Dollar over concerns that the shock in energy prices would stall economic growth in many parts of the world. Dollar strength continued as the Fed embarked on an aggressive interest rate hiking cycle. While other central banks have also been increasing their benchmark rate, the Fed has been one of the most aggressive in its bid to tame inflation. As a result, rates have shot higher in the US, bringing the Dollar up with them. The third quarter saw the DXY reach a cyclical high of 115, with the Dollar performing well against both developed and emerging market currencies, largely because recession concerns were top of mind, fuelling demand for the safe haven currency.
Emerging market (EM) currencies have exhibited relative resilience compared with developed market currencies such as the Yen and Euro. Thus far in 2022, emerging markets currencies are down around 10% versus the Dollar, whereas developed markets currencies are down around 15%. This relative strength is likely due to several factors, including aggressive and proactive central bank hikes in emerging markets, already cheap valuations and light investor positioning.
A strong Dollar generally poses headwinds for emerging markets, as they are often reliant on foreign investment and foreign capital, both of which can evaporate when the Dollar gains in value. At the same time, higher interest rates make it harder for EM nations and companies to pay their Dollar-denominated debts. On the other hand, a reversal of US Dollar strength may offer some respite for EM assets. Given how under-owned many EM assets appear, light positioning and attractive valuations may start to entice foreign capital back in, reversing the sharp outflows seen so far this year.
In previous periods where the DXY was relatively weak – such as the early 2000s, where it declined by 40%, and through 2020, when it fell by 12% from February to December – EM equities returned 27% and 19%, respectively.
The Australian Dollar – US$ Strength Rather than AU$ Weakness
Strong commodity prices have somewhat shielded commodity exporter currencies like the Australian Dollar (AU$), which has only weakened by 6% (although the AU$ was down 14% year-to-date at its recent October lows). The AU$ is among the best performing G10 currencies this year, and has actually appreciated against most other major currencies over the year so far. However, the AU$’s performance has been somewhat underwhelming relative to the strength of commodity prices this year.
Since the AU$ has a positive risk beta to global risk sentiment, it provides potentially positive leverage to a resolution of uncertainties such as a change in China’s zero-Covid policy.
Relative interest rates tend to be important drivers of currencies, particularly in explicit tightening and easing cycles. A relatively dovish hiking cycle from the Reserve Bank of Australia (RBA) has weighed on the AU$ this year and could continue to be a headwind. However, a genuine Fed pivot as inflation fears fade could well be the big currency story of 2023.
Relative to its long-term average, the AU$ appears undervalue. Over time, it rarely sits at this current valuation for long, so expecting a lift in the AU$ back above US$0.70 appears reasonable. We continue with a partial hedge of international equity exposures on this basis.
Is the US Dollar Bull Run Running out of Steam?
Easing US price pressure has boosted speculation that the Fed may be less aggressive in raising interest rates, bolstering the prospect that the Dollar has reached a peak. The notion of a slowdown in the pace of hikes has seen the positive Dollar impulse from US rates fade over the past month. The Dollar had its worst day since 2009 after October’s US inflation report surprised with slower growth in consumer prices, driving speculation that the Fed will ease the pace of its interest-rate increases sooner than expected.
The Dollar’s rise has been a justifiable story and if geopolitical risks persist, if the Fed stays the course, and if inflation does not reverse, then the Dollar could have room to rally further. Part of what happens to the broad Dollar is going to be correlated with what happens to the Euro and the Euro area outlook. While the prospect of a recession in the Euro area remains high, it limits the upside to the Euro and therefore presents a headwind to a sustained decline in the US Dollar in the near-term.
However, the key appears to be the path of US inflation. A definitive peak in the US inflation cycle would prompt the Fed to slow down its aggressive tightening cycle, arguably providing the necessary condition for the Dollar’s broad-based rally to end. More factors may be needed for a major and sustained reversal, however, including a peak in energy uncertainty in Europe and a shift away from zero-Covid in China.
This month has actually seen positive developments on all those fronts, with the US inflation report surprising to the downside, more dovish Fed speak, clear signs that China is beginning its shift to a ‘living with Covid’ model, and better than expected production data out of Europe. Markets are seemingly starting to finally consider the top of the US Dollar cycle, with major currencies reversing some of their year-to-date losses through November.
As noted, the US Dollar has seen an impressive run higher with a build-up of long positioning. This, alongside apparent overvaluation, suggests it could be ripe for a reversal. Recent sharp moves in the Dollar on better-than-expected inflation suggest it will not take much in terms of a shift in tone from the Fed to send the US Dollar lower.
Written by
David Cassidy, Head of Investment Strategy
David is one of Australia’s leading investment strategists.
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