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The writer is the former chief investment strategist of Bridgewater Associates
The dollar has been falling rapidly against a basket of currencies of its major trading partners after climbing steadily to a long-term high last fall.
Slowing market expectations for U.S. interest rates explain much of the shift, but not all. In fact, what happens outside the US is as important, if not more, important to understand the dollar’s recent weakness – and more importantly, where it’s headed next – than what happens inside the US.
It all comes down to the dollar’s unique position in global currency markets, which allows it to appreciate in two very different environments. Thanks in part to its global reserve currency status, the greenback can do well when the global economy is struggling. In this situation, investors want the relative liquidity and safety of U.S. assets, especially U.S. Treasuries. This is true even when such shocks are domestic, for example, after the 2011 US debt ceiling crisis.
But at the same time, when the U.S. economy is growing strongly—especially stronger than other countries—the dollar also strengthens. This is usually accompanied by expectations of relatively more attractive U.S. Treasury yields and stock returns, which increases demand for the dollar.
When the U.S. is doing okay, but no better (or worse) than other countries, the dollar tends to underperform. This environment generally means that U.S. interest rate differentials are unlikely to be a major factor attracting capital inflows to the United States. In such circumstances, U.S. investors tend to feel more confident about taking greater risks in foreign assets, especially when the outlook for those markets is improving. This is exactly what has happened so far in 2023 – the dollar is rapidly losing ground against most developed and emerging market currencies.
So what happens next? To see the dollar continue to depreciate, it is not enough to see that the dollar is expensive relative to history and that the US has a current account deficit that needs to be financed. Most likely, we also need to see continued favorable economic data from the rest of the world and continued policies that attract capital inflows. It’s possible, but far from certain.
Beijing, for example, is clearly stepping up to support growth as it grapples with the social costs of a quick exit from the COVID-19 erasure policy, with the Chinese government recently downgrading policy priorities for technology sector regulation and real estate deleveraging.
Stronger consumer spending, underpinned by a likely improvement in property market sentiment, will not only help improve expectations for hard-hit Chinese assets. It would also benefit regions around the world sensitive to China’s growth trends, from key commodities to the most popular tourist destinations for Chinese. This is undoubtedly one of the reasons why the baht is the best performing Asian currency so far in 2023 – part of the reason for the baht’s strength is the expectation that a large number of Chinese tourists will be ready to spend in Thailand.
At the same time, the warm winter has helped the economy in much of Europe to perform stronger than people had feared, with economic data coming in better than expected.
If we continue to see improving economic conditions in the rest of the world and a “perfect US disinflation” – enabling the Fed to slow its pace of rate hikes without unduly damaging growth – then the dollar could fall further. This will encourage investors to seek more attractive valuations and greater diversification through increased exposure to non-U.S. assets.
In addition to pointing to continued underperformance in U.S. equities, such a trend would ease some of the pressure on central banks abroad. These central banks have had to intervene and raise interest rates over the past few quarters in order to slow the currency sell-off.
But there is one caveat. After last year’s disastrous missteps by many market participants and central banks, it has become increasingly clear that humility is needed now – the potential for surprises remains high, whether it’s the reopening of China, the war in Ukraine, or even the Winter weather affecting energy prices.
Moreover, it is this global optimism that has brought the dollar back from its recent highs, which may sow the seeds for the next risk-off move. A sharp and rapid depreciation of the dollar would provide an unwelcome underpinning to US inflation – making the Fed more inclined to keep policy tight even if it meant a deeper recession. We live in a world with enough catalysts that could reignite concerns about global growth and stability, or cause the US to once again outperform other regions. For now, the dollar is down, but not necessarily out.