Ramping up the US dollar

Many analyst forecasted the US dollar would continue to plough on towards the 0.90-0.95 range for euro/dollar in coming months.

The Standard Bank has grappled with the possibility that the US dollar could rise much further than its target levels. Initially, it resisted, but now it thinks it more likely that the US dollar will continue to plough on towards the 0.90-0.95 range for euro/dollar in coming months.

Why the change? Mr. Steve Barrow, Head of Standard Bank G10 Strategy said there would be a number of factors. Some just reflect more intense manifestations of the reasons he became much more optimistic about the US dollar earlier in the year. For instance, he has always felt that inflation was going to prove a more significant global problem, even before COVID, based on trends such as deglobalisation and rising dependency ratios in advanced countries.

"Covid, and now the war in Ukraine, have speeded up these structural changes to a point where even we are shocked by just how much inflation has increased. This in itself is not a reason to expect a stronger dollar, except for the fact that the Fed has been much more determined than others in its efforts to reduce price pressure – and that is lifting the dollar", said Mr. Steve Barrow.

The CPI data from the US presented another clear sign that inflation is transitioning from a commodity/goods price issue to more of a labor/service-driven price pressure. That’s going to be harder to control; necessitating a fed funds target of over 4% in Mr. Steve Barrow’s view, and helping to provoke widespread recessions into the bargain. This tightening of financial conditions should spur the dollar to more gains through both rising rate differentials and rising risk aversion.

A second issue that has become more intense is the terms of trade deterioration for energy importers such as the euro zone and Japan. The euro zone, in particular, has seen a dramatic slump, as reflected in the fact that the healthy trade surplus has not just fallen but turned into a deficit this year.

Mr. Steve Barrow thinks the terms of trade deterioration is likely to cause more weakness in the likes of the euro and yen than he envisaged when the Russia/Ukraine conflict kicked off back in February. Another factor he would mention is that the global weakness in asset prices like stocks and corporate credit that we have been expecting does not look as if it is going to reverse at all soon.

On the contrary, there looms the very damaging prospect that financial market strains will move on from being based on areas like market prices and volatility to being based on funding and strong safe-haven demand. Should this happen, the US dollar is likely to rise further, with yen weakness possibly spurring very significant tensions in Asian currencies, while euro weakness compounds the threat of a new debt crisis in the euro zone.

How long is the US dollar strength likely to last? Probably many months as an unwinding of the factors that seem to be supporting the US dollar, such as policy tightening, recession risk, terms of trade strains and financial fragmentation are not going to end soon. So, as well as taking down our 3-month euro/dollar forecast from parity to 0.95, the Standard Bank has cut the 6-month call to parity from 1.05 previously.

Could policymakers decide to try to turn the US dollar around given that the currency has already reached 20-plus year highs against the likes of the euro and the yen? Mr. Steve Barrow thinks there’s a case to be made for preemptive FX intervention to try to avoid some of the nasty global consequences that are likely to result from further significant US dollar strength. But there’s sufficient global agreement on this, with the key player – the US – likely to be very reticent given that intervention would tend to go against the thrust of its policy, which is to tighten financial conditions.

"This being said, we may well get to a point where central banks have to step in to do something, but that’s only likely to be at levels much lower (for the euro) than we are forecasting, and probably only once the tide of monetary tightening in the US has turned," said Mr. Steve Barrow.