The dollar is hitting multi-decade highs against its trading partners, even with US inflation at its highest level in nearly 40 years. The US dollar index, which tracks the currency against a basket of others, hits highs not seen since 2002. The greenback’s rise sent the euro, pound and Japanese yen tumbling.
It’s a different story from the one that unfolded in the inflation-ridden 1970s. The dollar plunged nearly 40% against the West German mark, then one of Europe’s most influential currencies, between January 1974 and 1980, according to data from the Federal Reserve Bank of St. Louis. Federal Reserve Chairman Paul Volcker began in 1979 to raise interest rates sharply, fueling a strong recovery.
Investors argue that global economic weakness is behind today’s dollar strength. Covid-19 shutdowns in China have slowed industrial production in the region, and the war between Ukraine and Russia is driving up energy costs for European households, which depend on Russia for natural gas, and around the world. The eurozone economy faces the threat of a recession.
The situation in the United States is different. Consumers have more money in their bank accounts. Even as prices rise, Americans are spending. Data shows that companies are investing money in equipment and research and development. Fed Chairman Jerome Powell expressed confidence that the economy could withstand a series of interest rate hikes at the Fed’s policy meeting on Wednesday.
Traders will analyze consumer spending data and Friday’s monthly employment report this week for clues regarding the health of the economy and the trajectory of the stock market. US stocks fell sharply on Thursday, erasing gains from the previous session.
Chris McReynolds, head of inflation trading at Barclays and a former currency trader, said the dollar is outperforming other currencies as the outlook for inflation and growth in other countries is worse. The US dollar index has risen 14% over the past year.
“The US economy has been much less damaged by Covid than others,” Mr McReynolds said.
Rick Rieder, head of bonds and head of fixed income at BlackRock, said he was buying dollars and selling currencies hit by weaker economic growth relative to the United States, including the euro, Chinese renminbi offshore and small amounts of yen.
Currency derivatives markets indicate that investors expect the dollar to continue to outperform. Bank traders said clients buy options that pay out if the dollar continues to rise: Call options for the dollar against the yen became more expensive than put options in March, a reversal of a metric used by traders to gauge dollar demand.
A strong dollar allows Americans to buy goods from other countries at lower prices. But it can also hurt American manufacturers by making products more expensive for foreigners, and it means American companies get fewer dollars for their exports. Microsoft Corp. said in its earnings report earlier this month that a stronger dollar reduced the software company’s revenue, even though it posted higher profits last quarter.
In the 1970s, inflation and the 1973 Arab oil embargo dragged the greenback down. Europe is now grappling with its own energy supply shortages and growth issues, which could lead to a phenomenon known as stagflation, marked by rising prices and slowing growth, which often prompts investors to sell a currency. The euro has lost nearly 13% against the dollar over the past year.
Stephen Gallo, European head of FX strategy for BMO Capital Markets, said investors’ perception of how central banks will act is boosting the dollar. The European Central Bank has yet to raise interest rates, with President Christine Lagarde saying earlier this month that she would lag behind the Fed in tightening monetary policy. The Bank of Japan has also recently reinforced its commitment to keeping interest rates low.
Interest rate derivatives show investors expect the Fed to raise its benchmark federal funds rate from its current level of between 0.75% and 1% to just over 3% next year. .
“Central banks that are more credible in targeting inflation will attract most flows,” said Nafez Zouk, an analyst at Aviva Investors. “The Fed has finally signaled that it is taking the inflation problem seriously.”
Another reason for the dominance of the dollar: the constant outperformance of American assets compared to European assets. A measure of this can be seen in global equities: over the past decade, US equities have generated outsized returns for investors, while their European counterparts have remained subpar and largely constrained. The S&P 500 in December was up more than 400% since 2009, compared to a 137% rise in the Stoxx Europe 600 over the same period.
Keith Decarlucci, chief investment officer of London-based hedge fund Melqart KEAL Capital, which has been trading the foreign exchange markets for more than 30 years, said the dollar’s status as a safe haven amid geopolitical uncertainty and its role of the world’s reserve currency put it in a stronger position. today than in the 1970s, when the United States imported more oil and left the gold standard.
But Morgan Stanley and Barclays expect it to decline over the year. Strategists said the currency would not be as attractive if economic growth picks up in Europe or inflation in the United States remains above 3%.
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