Is the US dollar invincible, or just the best house in a bad neighbourhood?

Dollar strength has been a wrecking ball swinging through forex markets, buoyed by the Federal Reserve’s interest rate increases and severe problems facing other major economies
If the Fed were forced to cut rates – because the US enters recession or due to a threat to the global economy – the dollar would depreciate

Nicholas Spiro

Published: 1:30am, 23 Sep, 2022

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Just a cursory glance at the abysmal performance of leading asset classes this year shows there are few places for investors to hide. Among more than 35 assets across developed and developing markets tracked by JPMorgan, only two major ones have delivered positive returns.

The first is commodities, which have been driven higher by price shocks stemming from Russia’s invasion of Ukraine. It is the second, however, whose rise has been unrelenting and has more momentum behind it.

The US dollar has been on a tear, delivering its third straight month of gains in August. Since the start of 2022, the dollar index – a gauge of the currency’s performance against a basket of other major currencies – has surged 16.2 per cent to a 20-year high.

The US dollar’s rapid ascent has been a wrecking ball swinging through foreign exchange markets. While emerging market currencies have suffered, most of the damage has been in advanced economies.

The Japanese yen has plunged 25 per cent this year to its lowest level against the dollar since the 1997-98 Asian financial crisis, fuelling speculation that Tokyo will intervene to prop up the currency. The British pound has slid to its weakest level since 1985, while the euro has fallen below parity with the greenback for the first time since 2002.

The damage extends far beyond currency markets. Many countries and companies, especially in the developing world, borrow in dollars. When the US’ currency strengthens sharply, the cost of servicing dollar-denominated debt from revenues in local currency increases, resulting in a liquidity squeeze.

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Part of the reason the rally in the dollar has been so fierce is that the Federal Reserve has emerged as the most hawkish central bank among the world’s largest economies. The Fed’s aggressive interest rate hikes have turned the greenback into a high-yielding currency. The two-year US Treasury yield stands at 4 per cent, more than twice the level in Germany.

Yet, the underlying cause of the dollar’s strength is the more severe problems facing other major economies. To put it simply, the dollar is the best house in a bad neighbourhood.

To be sure, America’s economy is in a precarious position. Persistent and broad-based inflationary pressures, rising wages and a tight labour market are forcing the Fed to raise rates aggressively, making it more likely that an outright recession is the price that must be paid to bring inflation under control.

How US and European recession risks could play out for China

However, the United States is faring better than its main peers. Soaring energy costs caused by Russia’s “weaponisation” of gas supplies have hit Europe hard, dealing a severe blow to manufacturing activity and consumer spending. Germany’s economy, which is among the most exposed, is likely to start contracting this quarter.

While a euro zone-wide recession is a foregone conclusion, Moscow’s decision this week to escalate its invasion of Ukraine by calling up 300,000 reservists and renewing its threat to use nuclear weapons takes the conflict into a new and more dangerous phase. The euro looks more vulnerable than it did just a week ago.

In China, the toxic combination of Beijing’s disruptive “dynamic zero-Covid” policy and a crisis of confidence in the housing market is weighing heavily on the country’s economy and markets. More forceful stimulus measures are being blunted by the reluctance of consumers and businesses to borrow, fanning fears of a liquidity trap. Fitch Ratings expects China to grow by a meagre 2.8 per cent this year, just a tad stronger than the average rate for 20 leading economies the agency tracks.

The dollar is also benefiting from its role as a sanctuary in times of uncertainty. Investors seek refuge in the world’s dominant reserve currency even when the US itself is the source of the turmoil. This shows the extent to which the depth, liquidity and relative safety of US markets outweigh political and economic risks in the country.

Still, the dollar is not a one-way bet. If the Fed were forced to cut rates – either because the US enters recession or because of a systemic threat to the global economy – the greenback would depreciate. Even signs that the Fed is turning dovish would weigh on the US’ currency.

It is also possible that the dollar – which hit a new high on Wednesday after the Fed raised rates by an additional 0.75 percentage points and signalled further hikes in the coming months – becomes so strong that it starts to threaten the global economy, including a rapidly slowing US economy. This could lead to calls for coordinated global intervention to weaken the greenback, akin to the 1985 Plaza Accord.

For the time being, however, the dollar is, in the words of veteran bond investor Bill Gross, the “cleanest dirty shirt”. Given the Fed’s determination to rein in inflation at the cost of inducing a recession, the shirt in question is bound to get dirtier.

Nicholas Spiro is a partner at Lauressa Advisory