The “reopening trade” has posed a real challenge to King Dollar, but there could be a limit to how much power this monarchy is willing to give back.
The WSJ Dollar Index, which measures the greenback against a basket of other currencies, has been on an almost nonstop slide since the start of April. This past week, though, it has stood its ground, despite the fact that U.S. payroll numbers released Friday were weaker than economists expected.
It may be a sign that the dollar’s depreciation has largely run its course. If that is the case, it would remove a powerful tailwind from some markets, because asset prices denominated in dollars tend to move to offset shifts in the exchange rate. Commodities, for example, are up 32% in dollar terms since the start of the Covid-19 crisis, but only 17% in euros. As for oil, currently a popular bet, the currency has accounted for about two thirds of its gains.
Last year, a dash to safety initially pushed the WSJ Dollar Index up 8% relative to the start of 2020. As fiscal and monetary stimulus was deployed to fight the pandemic, the panic unwound. The move had completely reversed by November, but the dollar kept falling.
Anticipation of a synchronized global recovery tends to help shares that trade at cheap levels relative to earnings, which means looking overseas. European stocks have outperformed American ones in 2021.
Another factor making the U.S. less attractive to global capital is that the difference between interest rates there and abroad has narrowed during the Covid-19 crisis. And while the U.S. economy is now expected to grow faster than before, this doesn’t translate into higher rates anymore, because the Federal Reserve has announced it will cool economic activity only after consumer-price index growth tops 2%. Bond markets are still pricing in future rate rises relative to the rest of the world, but just in “nominal” terms. After adjusting for inflation, the gap remains very narrow.
It has widened in the past four weeks, though, which could indicate a floor. The positive impact of the pandemic recovery on rates overseas already seems to be priced into derivatives markets. The European Central Bank and the Bank of England also have been wary of tightening policy before the Fed in recent years. Meanwhile, Treasury markets may be exaggerating how high inflation is expected to go, as a result of some investors seeking to insure against worst-case scenarios.
It is also unclear which bond yield investors should treat as “the interest rate” when trading currencies. Inflation-adjusted ones are thought to be more precise, but a historical analysis by RBC Capital Markets strategist
recently underscored that short-maturity regular government paper has often been more correlated with exchange rates in rich countries. It makes sense: Inflation is an easy concept to define when all prices go up by a lot—like in the 1970s or in developing countries—but in most cases the CPI is an imprecise way to adjust for the “real” return investors get for investing in a country.
The U.S. economy is widely expected to outpace the rest of the world for the foreseeable future, and investors will ultimately accrue some of those gains, whether interest rates rise or not. Among the valid reasons for a weaker dollar, they shouldn’t overlook the forces playing in its favor.
Write to Jon Sindreu at firstname.lastname@example.org
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Appeared in the June 9, 2021, print edition.