The dollar, as measured by the dollar DXY index (measures the strength of the dollar relative to a basket of other currencies) is up 17.4% year to date. Over the last month or so alone, the DXY index is up 3.6%. Recessionary fears continue to be an important theme within the foreign currency market which continues to lead to the overriding risk-off sentiment amongst investors.
Rising inflation remains, for the most part, a global problem and so in response many central banks have been raising interest rates. The Reserve Bank of New Zealand, Norges Bank, Reserve Bank of Australia, Bank of England, Riksbank and the European Central Bank have all raised interest rates by 50 bps or more. Our South African Reserve Bank similarly raised rates by 75 bps following their September meeting. Central Banks are attempting to tighten financial conditions (by increasing interest rates) to bring inflation within target. The Fed has been one of the most aggressive in hiking policy rates. As a result, the 10-year U.S Treasury yield has risen from 3% to 3.7% in the last month. Compared to its counterparts, US yields are still in favor of the dollar, which has helped keep the dollar strong.
Our research provider (BCA Research Inc.) is of the opinion that the economic outlook in the U.S over the next five quarters will play out in three ‘acts’ of around nine months each.
Act 1 – Goldilocks (October 2022 to June 2023)
As Figure 1. illustrates, we are currently on the steep side of the aggregate supply curve. At this point, an increase in aggregate demand will push inflation up because the economy does not have enough spare capacity to produce more than what it is already producing.
As central banks continue to increase interest rates to curb inflation, demand will drop as the cost of financing becomes more expensive and financial conditions begin to tighten. The result will be that we slide down the aggregate supply curve (from AD0 to AD1). Should this occur, the result would be that inflation falls with relatively little loss in output.
Act 2 – The Second Wave (July 2023 to March 2024)
As Figure 2 demonstrates, inflation tends to come in waves. It is likely that this will be the case this time round. As inflation decreases over the coming months, real wage growth (wage growth adjusted for the effect of inflation) will likely turn positive and therefore real disposable income will rise too. This means more money in the pocket of the average consumer and so consumer sentiment will also recover. As such, aggregate demand will increase from AD1 to AD2, pushing us back up the steep side of the aggregate supply curve. Higher aggregate demand means higher prices and therefore higher inflation.
Act 3 – Recession (April 2024 to at least December 2024)
The second inflation wave is likely to catch investors and policymakers off guard. Most of them are assuming that the nominal neutral rate of interest is quite low and so may stop raising rates prematurely. BCA Research Inc. is of the opinion that the neutral rate is higher than what the Federal Reserve estimates and which therefore warrants an even more aggressive interest rate hike cycle to curb inflation than what the Federal Reserve currently projects. The neutral rate of interest is a theoretical rate of interest which is neither accommodative nor restrictive. It is the rate that supports the economy at full output while keeping inflation constant.
If this were to play out the Federal Reserve would need to start hiking interest rates again towards the second half of 2023. By that point, U.S mortgage rates will be over 8%, high enough to sink the housing market and the rest of the U.S economy. Housing markets abroad, which are in an even more perilous shape, will tumble too forcing a global recession.
As most countries have lifted Covid restrictions, China has maintained their zero-Covid policy. It is estimated that this policy is suppressing the level of China’s GDP by 4-to-5 percentage points. China is therefore unable to create a positive offset to the deterioration in global monetary and financial conditions. Furthermore, the most rapid decline in the yuan exchange rate in 5 years is producing an additional downside risk to the global economy.
The view of a global recession is consistent with a stronger dollar as the dollar tends to appreciate when global growth is slowing. This is already partly priced in as demonstrated by the dollar rally since 2021. Although the dollar is overvalued the sentiment towards it is very bullish and being a momentum currency is likely to continue performing well especially if risk assets fall.