Has the tide turned decisively against King Dollar? A fall of around 5% in the greenback versus major currencies in the past two months, pushing the dollar index to a 13-month low, suggests its post-pandemic surge has meaningfully faltered.
This comes hand-in-hand with a change in mood music from the Federal Reserve, which Chair Jerome Powell made plain at Jackson Hole last week: Interest rates have been kept high for long enough. The question at its next meeting on Sept. 18 is how big the first cut might be. Interest-rate differentials, and the implicit cost of hedging dollar exposure, aren't the only rationales for determining relative currency performance but they’re the dominant influences.
Stephen Jen, a currency hedge fund manager famous for the "dollar smile" theory, is predicting that an "avalanche" of up to $1 trillion of US-based assets may be liquidated and repatriated by Chinese companies, leading to a 10% gain in the yuan to the dollar. A stampede of that nature would certainly turn the smile upside down, since it would imply global trade had effectively stopped. The ongoing economic strength of the US compared to the struggling Chinese investment picture suggests this makes little sense.
However, a sustained series of Fed cuts should see the dollar further erode the haven premium it's so richly enjoyed the past three years.
That said, this is not a King Dollar being toppled from its throne story. Its premier reserve-currency status won't be threatened by a gradual downshift in valuation. The US is probably still the safest place to remain invested — with decent yields and a buoyant stock market — even if it’s no longer the slam dunk it has been. Nonetheless, the extreme volatility of early August has shaken the snowglobe thoroughly. Currency markets have been rudely awoken.
What does a weaker greenback mean for the rest of the world, which has been under its thumbfor so long? US-domiciled funds may look offshore for diversification as opportunities abroad start to reappear. Many global investors, too, will broaden their view.
But the economic benefits will spread far and wide. Usually, commodity-exporting economies tend to perform well when the greenback weakens, as the commodity-price correlation generally moves inversely to the value of the dollar. Nonetheless, after a very difficult few years, it’s likely to be broadly beneficial for most emerging markets, especially those with high import costs from commodities priced in dollars. That includes the resource-poor economies of China and India. There's the added benefit of the oil price falling in sync with a weaker dollar.
Of course, there are always exceptions for those with large trade and current-account deficits, or for other idiosyncratic reasons, that will struggle from unwanted strength against the dollar.
The largest of these is the euro area, and more specifically, the export engine of Germany. The German think tank IFO fears it’s "increasingly falling into crisis." Second-quarter German gross domestic product contracted for the third time in the past five quarters, hit by a double whammy of weakening consumer confidence and capital expenditure. A further bout of euro strength will only exacerbate the pain.
One positive byproduct of a stronger euro is reduced inflation expectations, thereby giving the European Central Bank more confidence to cut its deposit rate further. With a 175 basis point rate gap to the US, it's unlikely the ECB will be lowering rates in big steps, but it’ll shadow closely the path of US rate decisions to mitigate the currency impact for its export sector. The quickest way to invigorate the euro area, and underpin the longer-term value of the common currency, is for interest rates to come down. There's also the added benefit of lowering its huge debt-servicing costs. A stronger currency might be a necessary price.
Japan would normally be in the same boat as Europe — focused on keeping the yen keenly priced to make its exports competitive. However, the yen had simply become too oversold, so there is plenty of room for the Japanese currency to appreciate. About a quarter of total dollar weakness has been driven by the yen’s recovery, and it’s a feather in the cap for Japan that it has successfully intervened on its currency. History has rarely been kind to official attempts to stem market moves. But the Bank of Japan has been playing a skilful game of cat-and-mouse waiting for the Fed to signal a turn. Fewer BOJ rate hikes may be needed if the Fed embarks on an aggressive rate-cut cycle.
As well as being trapped in the dollar’s tractor beam, most Asian exporting nations are competing with each other not to suddenly have their currency become relatively too expensive. For the Chinese yuan and Korean won, removing the pressure of fighting against an omnipotent dollar will make it easier to cut interest rates when needed.
The Fed pivoting to an easier interest-rate environment will provide a global salve as it looks set to reduce the cost of doing business across the board. It will be a bumpy road, but even export-dominant countries will benefit in the long run.
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