Reason for the US dollar’s rise against major currencies

If the Fed’s likely rate cuts ease the global financial cycle later this year the impact is likely to be magnified if the ECB joins in, and the BoE and others. Photo. FED Chairman Powell

>> Long term outlook for the US dollar

Major currencies remain very stable, particularly euro/dollar. What’s more, falling implied volatility would seem to suggest that few see a way out of the impasse anytime soon. That seems understandable when you consider that market expectations are based on a largely simultaneous easing cycle from the major central banks (Japan excluded). But while interest rate differentials are undoubtedly important in currency determination we should not forget that even simultaneous easing should lead to a weaker US dollar over time.

Interest rate differentials between major central banks such as the Fed, ECB and BoE have not changed very much at all in recent years and that’s in spite of the fact that these central banks have tightened policy dramatically. If we look at the policy-rate differential between the US and the euro zone we see that this has widened by just 75-bps since the tightening cycle began, while the differential between the US and UK has widened by an even smaller 15-bps. That’s not much when you consider that the Fed has lifted rates by 525-bps in all.

Moreover, the market is pricing in a similarly benign situation for rate differentials as central banks ease. For not only are these banks expected to start easing at a broadly similar time; the scale of cuts is also expected to be very similar. The Fed is roughly priced for three 25-bps rate cuts this year, with the ECB priced for four and the BoE two or three.

As we know, it is only the Bank of Japan that’s seen any significant divergence of rate differentials in the past and the only one where this is expected to continue in the future. This is why dollar/yen has moved so much with the yen hit hard not just against the US dollar but against the euro and pound as well.

However, it would be wrong to say that the stability in rate differentials between the US and the euro zone, or the US and the UK has left the euro and the pound untouched against the US dollar. The euro started the tightening cycle in the vicinity of 1.15 and has since fallen below parity and still sits well below 1.15 at around 1.08 right now. As for the pound, it was around 1.35 before the tightening started and subsequently fell to near-parity before recovering to today’s rate of around 1.27.

In short, what we’ve found is that the US dollar has risen against the euro and the pound even though policy rate differentials have been very stable, particularly with respect to the UK. What does this tell us?

We think it primarily reflects two things. The first, and most obvious point is that interest rates are not everything when it comes to currency determination. For instance, the war in Ukraine and its impact on European energy prices dealt a big blow to the euro and the pound against the dollar. The second point, which we want to focus on is that, while rate differentials might get all the attention, particularly now that the market is sensitive to which of the central banks will cut rates first, the level of rates, and particularly the level of US rates is also important. Simply put; the dollar is more likely to go up when US rates rise and fall when they are cut, irrespective, of how these changes impact rate differentials.

What if FED will not cut rates this year?

As we have argued before, changes in US rates (and the dollar) heavily influence global financial conditions or what’s often referred to as the global financial cycle. When this cycle is one of tightening, due to higher US rates, global risk aversion tends to rise and risker assets are more likely to underperform their ‘safer’ alternatives; one of which is the US dollar.

Conversely, as the global financial cycle eases, via falling US rates, risk-taking is likely to improve and this is therefore more likely to weigh on the US dollar. Importantly, while this effect on the dollar is most likely to occur whatever the move in interest rate differentials, we can also argue that this global financial cycle effect is likely to be greater if other central banks are moving with the Fed, and hence keeping rate differential variation down to a minimum.

For instance, if the Fed’s likely rate cuts ease the global financial cycle later this year the impact is likely to be magnified if the ECB joins in, and the BoE and others. In short, static rate differentials are still likely to lead to a lower dollar in an easing cycle and perhaps an even lower US dollar the more stable rate differentials remain.