What is driving the strength of the US dollar?

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In mid-October, the US dollar was trading at levels not seen since the early 2000s, as the US Federal Reserve (Fed), under then-Chairman Alan Greenspan, raised interest rates to respond to a rapidly growing economy. In the past year, the US dollar The index, which compares the dollar to a basket of currencies, is up more than 20%, the biggest 12-month increase since 2015.

Forces Affecting Exchange Rates

When we consider what moves exchange rates, the prism of analysis remains the same regardless of which currency pairs are most relevant at the time and the relative levels of rates. Many factors influence exchange rates: actual and prospective economic growth, inflation, policies, institutions, resources, and financial markets. We can simplify the effects of these myriad factors by looking at how they flow into bilateral exchange rates through one of three channels:

  • Growth differential: the relative growth rates of country X and country Y
  • Liquidity spread: the relative availability of currency X and currency Y
  • Yield spread: the relative attractiveness of interest rates in country X and country Y

growth differential

Why did the US dollar appreciate against virtually all currencies, with a few exceptions, last year? The first channel to examine is significant and widening growth spreads.

The US economy was growing fairly strongly relative to other economies, with more substantial income support and double-digit gross domestic product (GDP) growth rates peaking last summer. By contrast, no other economy had a real annual growth rate approaching 6%.

Today, the euro/US dollar is the most critical bilateral exchange rate. Both are solid and reliable currencies backed by large economies with well-developed institutions and deep financial markets.

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The war between Russia and Ukraine and the associated sanctions have resulted in an eight-fold increase in gas and electricity prices in Europe. Suddenly, Europe cannot produce the same output without a significant increase in the cost of energy, an integral input for all economies.

The result has been a widening growth differential. The euro has depreciated around 20% against the US dollar since the second half of 2021.

Liquidity Spread

If we look at the second channel, the liquidity spread, we see that US dollar liquidity is still abundant, even though dollars are now more expensive.

There is no official metric for the availability of dollars, so we created an indicator using the cumulative US trade deficit, measured by the US trade balance minus the US oil balance and the US trade balance with China. (We subtract the trade deficit between China and the United States because Chinese dollars tend to get bottled up in the People’s Bank of China, due to China’s closed capital account, and don’t circulate as freely in the global economy as dollars held by China). other countries.)

When US trade deficits widen, more dollars flow out. Relative abundance means a depreciating US dollar, all else being equal. On the other hand, when the United States consumes less from abroad and its trade deficit shrinks, as it has been doing since March, fewer dollars are available for international trade.

A rapidly appreciating US dollar is particularly precarious for emerging market economies. Their demand for dollars is much stronger because their national currencies are weak and they do a significant part of their business in US dollars.

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performance differential

The third channel that affects exchange rates, the performance differential, too has been underpinning the dollar’s bullish move. The Fed has embarked on a significant campaign to raise interest rates. For stablecoins, when interest rates rise in a country, investors get a higher return in that country for the same level of risk. As a result, the dollar’s yield spread against other currencies looks much more attractive now.

For example, both the Japanese yen and the US dollar are strong currencies, so trading the yen against the dollar is perceived as relatively risk-free. Relative to the Fed, the Bank of Japan is not raising interest rates, so rates for Japanese savers are not very attractive in local currency. However, they are becoming much more attractive in dollars. Therefore, we are seeing a flow of yen into dollars, an investment strategy known as a carry trade.

US dollar strength

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Possible changes to watch

What could break the trend of rapid appreciation of the dollar? Looking at our three channels that affect interest rates, the Federal Reserve could lead the United States into a recession. If other economies manage to sustain stronger growth rates, or at least experience milder recessions, the growth gap between the US economy and everyone else would at least stop widening and may even start to narrow. On the other hand, a US recession could drag other economies down with it, an outcome that would continue to support the dollar.

Another change that could affect growth differentials would be a sustained drop in energy prices in Europe. We expect energy prices will likely start to decline as European countries build liquefied natural gas (LNG) terminals and perhaps even establish a pan-European energy market. As energy prices decline, all else being equal, Europe’s economic prospects will improve considerably. The growth differential between the United States and the eurozone would begin to narrow and the euro would appreciate against the US dollar.

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If the US economy were to slip into recession, the Fed could pause its interest rate hike campaign, which would mean that yield spreads would stop improving. The US dollar would no longer look as attractive relative to other currencies. Carry trades could relax.

At the same time, a US slowdown would likely cause the trade deficit to shrink further as consumers bought fewer imported goods. A shrinking trade deficit would affect the liquidity spread because fewer dollars would be available. This impact would mitigate pressure on the dollar from contracting growth and yield spreads.

Overall, the path of the US dollar is likely to depend on relative economic growth, or lack of it, and the decisions of central bankers. The divergence from current growth, liquidity and yield trends could put the dollar on a different course.

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Publisher’s note: The bullet points in this article were chosen by the editors of Seeking Alpha.

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