There are a number of ways in which investors try to ascertain the future direction of a currency. Looking at the US dollar, some investors look at the equity markets to call the move in the dollar. The US market remains an important safe haven destination for times when the investment landscape turns risk-off. These safe haven inflows into the US creates extra demand for the dollar which boosts its value. In the past this has held true, when the equity market collapses and risk sentiment turns negative, the dollar receives a boost from safe haven flows into the US markets.
Investors also typically look at bonds and their associated flows to call the direction of a currency. Interest rate differentials (the difference in interest rates between two similar interest bearing assets) is a key driver for currencies. Simply put, higher interest rates on bonds in a particular country makes those bonds more attractive to investors. As a result, foreign investors take up the higher yielding bonds which boosts the demand for that countries currency which ultimately boosts the currency’s value.
A further indicator, perhaps less used, which is important in calling the next move in a currency is bond volatility. In the context of the US, the MOVE Index (Merrill Lynch Option Volatility Estimate Index) is a measure of the implied volatility in the US Treasury bond market. It measures the market’s perception of future price swings or volatility in the US bond market. High values of the MOVE Index indicate higher expected volatility, which may suggest uncertainty or concerns in the bond market. Figure 1 shows how the dollar has tracked bond market volatility over the years. As bond volatility increases so too has the dollar, and vice versa.
Currently the MOVE Index sits at 131, interpreted this would suggest that volatility is still relatively high. It’s likely that we will only see a meaningful retraction in volatility once central banks have contained inflation. This is an indication that the dollar still faces upward pressure for the time being.
The dollar is a counter-cyclical currency, which means that it appreciates when US economic growth is relatively higher than global economic growth, and vice versa. Currently, the US economy is still outperforming the rest of the world (although growth outside of the US is starting to show signs of a recovery) which furthermore underpins the view that the dollar will hold firm. See Figure 2.
When looking at global growth prospects, China has a huge role to play. Although some data out of China has provided a positive surprise, as BCA Research highlights, this is an indication that the Chinese economy is stabilising as opposed to rebounding and that Chinese economic growth will remain muted for the time being. Recent Chinese Manufacturing Purchasing Managers’ Index (PMI) data, which shows the prevailing direction of economic trends in the manufacturing and service sectors, delivered a negative update in October reflecting weaker demand for Chinese goods. See Figure 3.
The team at BCA Research remains comfortable with their view that the global economy will succumb to a recession in the second half of 2024. This is mainly because the full effect of the increase in interest rates and tightening of bank lending standards has yet to be felt. Although the severity of the recession is still to be seen, it will have a negative impact on global growth which may also provide support for the dollar.
Currently, there are more factors which support the view of a strong dollar for now than not. That being said, from a technical perspective the dollar is ripe for a correction. First, the dollar remains overvalued. It currently trades at a premium of around 20% above its Purchasing Power Parity (PPP) exchange rate. Historically, the dollar’s deviation from PPP has been a good guide to its long-term direction. If this is to hold true, it would imply that the dollar over the long term will move towards its fair value (in this case the dollar would need to weaken).