What’s behind the dollar surge? Look to Europe, not US interest rates
Nicholas Spiro says the rise in US Treasury yields has contributed to the dollar’s rise but the slowdown in the euro-zone economy has been a more influential factor. Not surprisingly, quantitative easing appears here to stay, in Europe and Japan
The world’s financial markets are influenced by a multitude of factors, which is why it is a mistake to place too much emphasis on one particular development or trend.
Yet, over the past several weeks, it has been all about the surge in the US dollar.
Since April 16, the dollar index, a gauge of the greenback’s performance against a basket of other leading currencies, has shot up more than 4 per cent to its highest level since the end of 2017. Last month, the dollar enjoyed its best month since Donald Trump’s victory in the US presidential election in November 2016.
As I argued in an earlier column, a rebound in the dollar was overdue, given the growing divergence in global monetary policies. While the Federal Reserve has become increasingly confident in raising interest rates further as inflation picks up, its European and Japanese counterparts are in no rush to end their quantitative easing (QE) programmes, given the persistence of subdued inflation.
While this divergence failed to buoy the greenback last year – despite the Fed’s four interest rate hikes between March 2017 and March 2018, the dollar index fell 11.5 per cent – the correlation between government bond yields and exchange rates appears to be reasserting itself. The rise in the benchmark 10-year Treasury yield to the symbolically important 3 per cent level, coupled with the doubling of the yield on its policy-sensitive two-year equivalent since September 2017, have contributed to the recent rally in the dollar.
Yet the main source of support for the strengthening greenback – and one of the most important drivers of markets right now – is the sudden deterioration in Europe’s economy.
The euro, which has a nearly 60 per cent weighting in the dollar index, has fallen 4.3 per cent against the dollar in the past month, having surged 18 per cent between April 2017 and February 2018. The single currency has come under strain because of the marked slowdown in the euro-zone’s economy at a time when US growth remains robust. On Monday, the publication of a report from IHS Markit, a data provider, showed that retail sales in the euro zone contracted last month for the first time since March 2017.
The under-performance of Europe vis-à-vis the US is showing up in bond markets. While the 10-year Treasury yield has breached the 3 per cent mark, its German equivalent has fallen 20 basis points since February, to 0.5 per cent, increasing the spread between the two countries’ respective borrowing costs to its widest level in nearly three decades, according to data from Reuters.
If the recent deceleration in growth in the euro zone persists, currency investors could start to turn bearish on the euro, further bolstering the dollar. The core inflation rate, which strips out volatile food and energy prices, in the bloc has already dropped below 1 per cent, half the European Central Bank’s (ECB) target, for the first time in more than a year.
Investors’ big short positions on the greenback, and their bullish bets on emerging markets, have already gone awry as the surge in the dollar and Treasury yields reduce the value of dollar-denominated emerging market bonds and raise fears about companies’ ability to repay their external debts.
JPMorgan’s emerging markets currency index, a leading gauge of the performance of 10 major currencies against the dollar, has plunged more than 5 per cent since the end of March, its sharpest fall since the fallout from China’s surprise devaluation of the yuan in August 2015. Argentina has just been forced to seek aid from the International Monetary Fund to help shore up its plummeting currency, while there are mounting fears about a full-blown financial crisis in Turkey.
Still, while Europe’s economic slowdown is fuelling a rally in the dollar, it is also making it more likely that the ECB will be forced to prolong its quantitative easing programme which is meant to expire in September.
The prospect of more monetary stimulus in Europe for longer than investors currently anticipate would not only buoy Europe’s debt markets, it would also help keep global bond yields at relatively low levels, especially given the additional support from the Bank of Japan’s QE scheme in the face of continued tightening in US monetary policy. Algebris Investments, a UK hedge fund, believes that the European and Japanese central banks will not even have time to start raising rates because of an excessive Fed-driven tightening in financial conditions that will hurt the global economy.
For an indication of how much further the dollar is likely to strengthen, but also for a sign of how much scope there is for leading central banks to normalise policy, look no further than Europe’s slowing economy.
Nicholas Spiro is a partner at Lauressa Advisory