US dollar is still struggling to rally

Currency markets remain very stable. In some ways, that’s all the more surprising given that much of the news coming through from the US seems to be very positive while the likes of China and Europe continue to languish. Last week, we saw Fed Chair Powell suggest that the bank is experiencing an almost ‘pinch yourself’ moment as inflationary pressure eases while the economy remains very robust. Powell described it as an “unusual situation,” and that’s not just true in a historical sense but also compared to other countries, particularly in Europe, where inflation’s fall has come at the cost of flatlining growth.

This is US exceptionalism on steroids, and hence, it seems all the more surprising that the dollar is not much stronger. It’s only gains of note for some time have been against the yen, but the Japanese currency has lost ground across the board due to the BoJ’s refusal to hike policy rates. When this changes, as it could from around the spring, the dollar might even lose its strength against the yen. So why is the US dollar failing to rally?

There could be many explanations. One is that this situation is not very new, and hence traders and investors are already sufficiently positioned for such outperformance. Probably another factor is that many will think that the US economy cannot defy gravity for much longer and, as the economy slows, the US dollar will fall in tandem.

For instance, while the focus last Friday might have been on the 353k surge in non-farm payrolls, the alternative employment measure from the survey of households showed a 31k fall. This latter measure of employment is far more volatile, but if we smooth it out by calculating a 12-month average, it does appear that the employment picture might not be as robust as payroll data make out.

We dare say that many traders and investors suspect that the US economy will crack at some point and that the dollar will slide when it does. Our own forecast, for instance, is that a 2% US growth advantage over the euro zone in 2023 will likely slide to around 1.25% this year. Yet another argument, perhaps somewhat counterintuitively, is that the US’s very outperformance can hold the dollar in check.

If we look at stock market performance, for instance, we see that so far this year, the S&P 500 has risen by around 4% against 0.5% for the Stoxx 50 in dollar terms. This continues the US outperformance that we’ve seen for some time, but there are two senses in which this can weigh on the US dollar.

The first is that those investors who choose to maintain fixed country weights for their asset allocations will re-weight every month or every quarter by reducing exposure to the outperforming market – the US – and if this involves selling dollars into the bargain it can weigh on the value of the greenback.

A second issue is that a large portion of asset purchases appear to be financed not through buying currencies outright but by borrowing currencies via swaps. What’s more, most of the borrowing is in dollars, even if the final investment is not into the US stock market.

Should US equities rise, and particularly if they rise more than other bourses, those that have borrowed dollars to fund the investments can adjust their hedges due to the valuation gain, and that can involve selling dollars into the spot market. Hence there can be an almost natural tendency for the dollar to be restrained from gaining when US assets are outperforming.

A key question is whether this stability of the dollar will persist should the US continue to outperform, both in terms of growth and asset prices. For the most part, Mr. Steve Barrow, Head of Standard Bank G10 Strategy suspected that it will. A shrinkage in the US’s growth outperformance does seem likely to pull the dollar back later in the year. But he doubted that it will be substantial except, that is, in the case of the yen which is likely to be an outlier with its global strength in 2024. For euro/dollar, he feels that the lower end of the 1.05-1.10 trading range, which has been in place for the best part of a year, is the more vulnerable in coming months. But looking further out, as euro zone growth recovers the upper level should be broken decisively with a move to 1.15 and above expected a year out from today.