Tailwinds for USD

The dollar looks set to stay at the front of the G10 currency pack.

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The dollar remains in ascendancy and we do not see this changing for now. Stagflation risks are uppermost in Europe, particularly in the UK, and this seems likely to keep the euro and sterling down against the dollar. For, while the Fed appears set to continue raising rates at a rate of 50 basis points per meeting, the ECB and BoE are likely to opt for more cautious tightening, and thus yield differentials, at least at the front end of the curve, should remain supportive of the dollar.There are rumblings of concern about the impact weak currencies could be having on inflation, notably from Japan but also more recently from the euro zone.

However, Mr. Steve Barrow, Head of Standard Bank G10 Strategy regards the chances of any central bank action to stem currency weakness as very remote, even if, as he suspects, the euro/dollar slips to the psychologically important parity level. He feels that, for any sort of central bank response to occur, he would have to see global risk aversion rise so far and so fast, partly through dollar strength, that it forces the Fed to step in. This is certainly possible.

The global economic environment is poor as stagflation fears rise, while riskier assets appear to be at elevated levels with no hope that central banks can cut rates if asset prices tumble. This makes the environment very dangerous and certainly one in which dollar strength and other asset price movements could tighten global financial conditions well beyond the extent required to reduce inflationary pressure.

This being said, for the US at least, financial conditions on the Chicago Fed index are still at a reading below zero, which means that they are not deemed as tight. In other words, although financial conditions have tightened, in part because of the strength of the dollar, there is still a very long way to go before the Fed might consider that conditions are too tight and that something might need to be done about dollar strength to ease them.

"Financial conditions will tighten a lot further and need to tighten to bear down on high inflation. But the odds of this creating some sort of coordinated global effort to pull in dollar strength over the next year, or more, still lies below the 50% probability line in our view", Mr. Steve Barrow said.

This being said, there are factors that could "naturally" pull down the dollar. For instance, rising inflation and rising bond yields have pulled many bonds away from yields that are below zero. At its height, the stock of negative yielding global debt was over USD 18 trillion; it is now less than USD 3 trillion, which is the smallest amount in well over a decade. Given that this negative debt has been concentrated in the likes of the euro zone and Japan, we can argue that it has been a negative factor for the euro and the yen.

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Net purchases of overseas debt by euro zone investors reached a peak of EUR800bn in annual terms during the pandemic as euro zone investors tried to find higher yields abroad while foreign investors shied away from low euro zone bond yields, especially from the US where yields were still positive. It is not unreasonable to believe that this factor has curtailed the euro and we might also argue it has been similar on the equity side, as US stock returns have seemingly been much more attractive than those from the euro zone for some time.

But even if capital flows do turn more positive for the euro, we have to recognise what has happened recently on the trade front, which is a huge deterioration. This, though, should prove temporary as strong exporting nations, such as Germany, are weighed down by supply chain difficulties at the moment. As these ease and trade improves, the balance of payments position in the euro zone should become more conducive to euro strength.

"We have cut our euro forecasts pretty dramatically since Russia’s invasion of Ukraine; taking our longer-term targets for euro/dollar down from the 1.40-plus region to 1.25 today (for our two-year forecast). Hence, at this stage, we are still being cautious about the extent that the euro – and other European currencies – can climb against the dollar given the hugely adverse terms of trade shock that comes from the conflict in Ukraine", Mr. Steve Barrow said.