Gauging Recent Dollar Strength

by Sean Tweedie | December 1, 2021

After a long period of range bound trading, the DXY has finally broken out. For much of the year we saw the DXY index (an index which tracks the strength of the dollar against a basket of major currencies) trade between 89 and 94. In an earlier edition of this publication we indicated that a break above 95 could indicate a renewed dollar bull market move. Very recently we saw an aggressive break out with the DXY reaching 96.8, levels seen previously in July 2020. Although this move is significant, we are skeptical as to call a renewed dollar bull market just yet.

The appreciation in the dollar has been largely a result of rising US inflation and the perceived potential response of the Federal Reserve. The premise being that if inflation does not prove to be merely transitory (which is what the Federal Reserve has reiterated), the Federal Reserve would need to tighten monetary policy (raise interest rates) more aggressively than previously planned. US CPI inflation surprised to the upside and accelerated from 5.4% to a nearly 31-year high of 6.2% y/y in October. The market is now pricing in that the Federal Reserve will raise interest rates faster compared to what was priced earlier this year. The Overnight Index Swap (OIS) curve is now indicating two rate hikes by December 2022. See Figure 1. This US economic data which has been strong has further supported the dollar. Within the G10, the Citigroup economic surprise index (which measures the degree to which the economic data is either beating or missing forecasts) is much higher in the US (+19), than say, the euro area (-50) or Japan (-74). Another important release this past month was the US was the jobs report. Nonfarm payrolls increased by 531,000 jobs and unemployment fell to 4.6% in October.

Figure 1

The global growth outlook has also taken a bit of a knock due to the slowdown in China. While global export growth has remained relatively resilient, the narrative is that the slowdown in Chinese demand is leading to a genuine slump that will impact commodity import demand. The surge in COVID-19 infections across Europe is creating further negative pressure on global growth. In an environment where global growth is weak relative to US growth, the dollar tends to stay strong. This is because the US is more isolated against global growth as exports only account for around 10% of US GDP.

During their November Federal Open Market Committee meeting the Federal Reserve announced plans to taper their asset purchases by $15 billion per month, with tapering expected to be completed midway through 2022. From a relative standpoint, the Fed is lagging many other major developed market central banks in normalizing monetary policy.
See Figure 2.

Figure 2

Many developed and emerging market central banks have already begun tightening monetary policy in response to higher inflation. If the US continues to lag other economies in terms of raising interest rates, interest rate differentials will be stacked against the dollar and which will lead to an outflow out of the US and a weaker dollar as a result. See Figure 3.

Figure 3

Last week the news of an Omicron variant saw a rush to safety in which the dollar found strength and risk assets sold off. The rand was one of the hardest hit currencies following the news. We still do not have all the facts around this variant, however preliminary results indicate that it is not a cause for panic. An outcome whereby the omicron variant has a similar impact to the delta one would ultimately have a fleeting impact on financial markets. However, if the latest variant poses a more severe risk – via its transmissibility, virulence, and ability to evade vaccine protection – then we may see a more pronounced impact on risk assets. In this scenario, a threat to the healthcare system could prompt authorities to reintroduce restrictions (although European protests demonstrate that the appetite for restrictions is much lower than in the past, which raises the bar for another round of lockdowns). The financial market impact would be characterized by a period of weakness for risk assets. However, a significant deterioration in economic activity is also likely to be accompanied by more fiscal stimulus and less monetary tightening, which would smooth out the longer-term impact.


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