The dollar’s run is based on rates, recession and risk
The dollar has performed exceptionally well in the first half of 2022 – and more broadly in the prior year. The fundamental stars aligned between a Fed tightening regime, perceptions of a bigger cushion for the US economy amid forecasts of a global slowdown and the reliability of the currency’s deemed safe-haven status. All of these are still in play heading into the second half of the year, but the relative potential has deflated. The disappointing continuation of the greenback despite the Fed’s 75 basis point hike in June or the strong sell-off of the S&P 500 in the first half of the same month probably indicates the limits of dollar support for the various dimensions. . Can the benchmark currency extend its incredible rally into territory that hasn’t been charted for two decades or does it find a peak?
Rate of hikes that are not unique
Over the past six months, the subject of inflation has moved from scholarly debate among economists to widespread fears about the country’s ability to absorb price growth not seen in four decades. Over the period, the Fed shifted from reliance on the “transitory” nature of inflation to a hasty struggle to avoid the troubling and stubborn rise. The central bank started with a 25 basis point (bp) rate hike in March, which it increased to 50 bp at the next meeting in May, followed by a steep 75 bp hike (the largest in decades). decades) at the June gathering. This is an aggressive policy with one-point swap pricing for the benchmark rate at 3.59% by the end of the year with a range of 1.50-1.75% approaching the second trimester. It is extraordinary in historical terms; and in a vacuum, that could perhaps keep the dollar on a steady bullish path.
Yet exchange rates are not a vacuum. Rather, they are determined on a relative basis. Although the Fed has earned a significant upfront bonus to fight inflation this year, many of its other major counterparts are catching up – or have already exceeded the outlook for the United States. The RBNZ and RBA forecasts see their rates end the year above the average Fed Funds rate, while the BOC and BOE are quite close. That said, it is the policies of the ECB that interest me the most for the influence of the dollar. While the ECB has been one of the most dovish central banks over the past decade, it has signaled its capitulation to the fight against inflation itself. As the European group (the second largest) raises its forecast, it may significantly reduce the perceived value of the dollar via EURUSD.
Chart 1: Relative monetary policy stance
Created by John Kicklighter
Recession fears grow
Interest rates only matter to the extent that markets are healthy enough to chase higher yields. In an environment where fear reigns, it takes far more promises of income to mitigate the threat than significant losses will result from maintaining exceptional exposure in the markets. There are many ways to measure risk, but the traditional macroeconomic outlet is through economic activity. During the IMF’s Spring Economic Forecast (called “WEO”), there was an overall downward revision to the forecast, but the United States received a smaller cut than most of its peers.
The drums of the economic downturn are getting louder as we approach the second half of the year, but the first vestiges of the contraction were yet to appear in the official data. Instead, the signals came from sentiment surveys (e.g. consumer, business, CEO, etc.) as well as certain market measures (for example, the spread of US Treasury yields from 2 to 10). With the sense of impending impact, there is a diffusion of risk when it comes to relative disadvantage. In other words, the fears are not tied to one economy or another, it just weighs the overall perception of risk collectively. As we start to see official readings of economic contraction that could lead to an outright recession, we will see relative status come into play. And, given that the US and the dollar already have some perception of resilience , there is more to lose than to gain in the future.
Figure 2: Global search interest for key terms
Source: google trends; Prepared by Kicklighter Jeans
What security does the world seek?
As inflation persists, as financial accommodation retracts, as the economy slows, we will see capital markets become increasingly unstable. In moderate levels of risk aversion, there remains an appetite for relative safety and yield. This nuance can present a country/currency with an economic trajectory comparable to that of the United States, but a higher rate of return and direct capital away from the greenback. However, the more risk aversion intensifies, the more the field of relevant safe havens is reduced. At the most extreme end of the risk curve (risk aversion), the dollar and US Treasuries/money markets are categorized as “last resort”. When the most important decision is liquidity and the ability to stabilize capital holdings, the dollar historically reverts to its frequently referenced safe haven status.
Chart 3: Relative risk positioning of key currencies/assets
Established by Kicklighter Jeans
Notably, although US stock markets fell into bear markets during the first half of 2022, there was no sense of panic in the movement. I look to metrics like the VIX rising to 50-70 or the main market yield spreads rising as indications that this degree of fear is entering the system. It should be emphasized that such intense measures of fear are destructive, but they are also short-lived periods.