US dollar could rally for safe-asset reasons

Currency forecasting is not easy for two reasons. The first is that we don’t know what is going to happen in the future with respect to those things that we might expect to move currencies, like growth, trade, monetary policy, politics and lots more besides. The second reason, which is the real coup de grâce for currency forecasters, is that very often, even if you knew all of this information in advance, the resulting forecast would still be wrong.

For instance, if we take the dollar, there’s probably a good argument ex-post that the US dollar should have strengthened given how things have turned out in the past year, or so. The US dollar index against other major developed currencies (the DXY index) is exactly where it was a year ago yet, in that time, we’ve seen the US grow more than two percentage points more than its peers. It is US exceptionalism on steroids and yet it has done nothing to the currency, particularly euro/dollar which has struggled to move outside of a tiny 1.05-1.10 trading range. This lacklustre performance for the dollar leaves two questions.

The first, and very obvious one is, ‘why’. And the second asks whether the dollar is actually very vulnerable going forward because its inherent inability to rally on good news might mean that it is very vulnerable to a slide when the news is not so good. On the first of these there are probably a myriad of reasons why the dollar might not have performed much better.

Valuation is one because, in real terms, the US dollar’s trade-weighted index is not quite at the highs seen in October 2022 but it still less than 4% below near-40-year highs. It has also risen by close to 40% since 2011. Such a sharp rise and such lofty levels may clearly be scaring off some who might otherwise buy the US dollar. The high valuation has also drawn forth currency intervention, from Japan, which could be another factor playing on the mind of any US dollar bulls. Another explanation could be that, while growth differentials have been wide, that’s not been the case for rate differentials (with the notable exception of the yen, hence the BoJ’s intervention).

A third issue is that robust growth is being “bought” by injudicious fiscal expansion which potentially creates vulnerability in the dollar if those overseas investors helping to finance the rising deficit decide to shy away over excessive deficit fears. This is certainly not an exhaustive list and hence might not include the “real” reason why the US dollar has not performed better.

But what about the second question? Does the dollar’s refusal to rise, in spite of this significant outperformance of not just economic growth, but also asset prices, like stocks, tell us that the greenback could become vulnerable if, or when, the economic tide turns against the US? We suspect that the answer is ‘yes’. But a related question is ‘when’ might this happen because there are scant signs at the moment, what with the most recent data showing that the likes of the UK and Japan slipped into recession in the second half of last year. So, barring some quick collapse in the US economy, which seems unlikely, any narrowing of this growth gap will take time and so will any slide in the dollar. Of course, other factors could bring about a quicker fall in the dollar although we have to be careful here.

For instance, if US stocks were to suddenly erase all of their advantage over most other G10 equities in the form of a deep slide this would presumably lift the US dollar, not sink it, as a stock plunge would lift global risk aversion and this normally plays into the hands of “safe” currencies like the US dollar.

Similarly, if an adverse shock were to happen in the US, or elsewhere, which forces the Fed to slash rates, and so narrow any rate advantage over G10 peers, we’d still expect the US dollar to rally for the same safe-asset reasons. In other words, what dollar bears have to hope for is that the US loses its ‘exceptionalism’ advantage, but does so in a benign way, not a malign one.