Will the dollar magic wear off?

Since the end of 2020, the dollar has risen by more than 26 cents against the euro. The currency was hit by a succession of rising US interest rates and turmoil in financial markets. But what will happen when those tailwinds die?

For many companies, the time for the year-end interviews is approaching again. Now imagine that you are approached during a meeting in mid-January that you have not yet achieved your annual goals. That's roughly what happens in the world of central bankers. The US central bank (Fed) aims for full employment and long-term inflation of around 2%. Currently, about one in 2,7 Americans in the workforce is out of work. And inflation, at an average level of XNUMX% over the past ten years, is not very far from the target. Still, the Fed is getting a lot of criticism.

The Fed Didn't Do It
The reason, of course, is that inflation has risen far too high in the short term. This is mainly the result of all kinds of problems in supply chains in the wake of corona, followed by soaring energy prices due to the war in Ukraine. The Fed can do little about the short-term inflation being miles away from its long-term target. Admittedly, the Fed should have moved a little earlier. But meanwhile, the inflation fire has been quenched with enthusiasm with an impressive series of rate hikes. In the spring in particular, the impact this has on the dollar was noticeable. 

Renterally and fear upsurge
At the time, American interest rates were already rising, while the European Central Bank (ECB) was still working hard to reduce the support package after corona. As a result, the dollar rose by more than 6% against the euro in March and April. Subsequently, the currency rose another 7% in the summer months. However, this rally had a different cause, as European interest rates rose at the same rate as US interest rates during this period. Rather than interest rate differentials, the dollar was boosted during this period by fears of a rapid cooling of the global economy. The US currency has been an attractive haven in view of the energy crisis in Europe, while China is struggling with corona lockdowns and major problems in the real estate sector.

Fuel for the dollar has run out
The big question is what could be a driver for the next dollar rise. Another inflation shock? A lot really needs to happen before the Fed ventures into even greater rate hikes than the 75 basis points already priced in for its upcoming meetings. Further escalating concerns about the global economy? Most sentiment indicators are already at their lowest levels since the financial crisis of 2008. It seems that the fuel for the dollar's rocket flight is about to run out. Several US investment banks have recently been advising their clients to stop hedging the currency risks of an investment in foreign equities, so that they profit if the euro, yen and other currencies rise. For now, however, 2022 is definitely the year of the dollar in the currency world. But it must be very strange if that also applies to 2023.

Joost Derks

Joost Derks is a currency specialist at iBanFirst. He has over twenty years of experience in the currency world. This column reflects his personal opinion and is not intended as professional (investment) advice.

© DCA Market Intelligence. This market information is subject to copyright. It is not permitted to reproduce, distribute, disseminate or make the content available to third parties for compensation, in any form, without the express written permission of DCA Market Intelligence.