A mix of stabilizing interest rate differentials between the U.S. and developed markets, combined with more confidence around global growth, is needed.
Gabriela Santos
Global Market Strategist
Gabriela Santos:
Hello. My name is Gabriela Santos and I'm a global market strategist at JP Morgan Asset Management. Welcome to On the Minds of Investors. Today's topic is when will the US dollar peak?
After 15 years of appreciation against foreign currencies, the dollar already came into this year very overvalued. Despite this, it's rallied a further 13% year to date to a 20 year high. This strength presents a very mixed backdrop for the US economy by dampening inflation, but dragging on real economic growth due to a widening trade deficit.
For US investors, the currency strength exacerbates concerns about S&P 500 earnings growth and acts as a drag on international equity returns. Globally weaker currencies are no longer seen as a positive as it fuels inflation concerns. So investors around the world would now really welcome a weaker US dollar.
But when will it peak? A mix of stabilizing interest rate differentials between the US and developed markets combined with a lot more confidence about global growth is needed. This is unlikely in the very short term, but gravity seems likely to exert downward pressure on the dollar sooner rather than later.
At first glance, a strong dollar may seem like a positive and there are advantages. Overseas trips are cheaper for US tourists and foreign goods are cheaper to import for US companies and consumers helping to bring down elevated inflation. But there are also important disadvantages. US exports are more expensive for foreigners and foreign earnings of US companies are dragged lower. And in fact, net trade was a big drag on first quarter GDP, subtracting 323 basis points from growth, and US companies have cited the strong dollar as a headwind to second quarter earnings.
A rule of thumb is that this year's 15% year over year dollar appreciation may shave off about 60 cents off S&P 500 operating earnings per share. Both of these are very unwelcome developments given concerns about recession risk and elevated earnings expectations,
Globally weak currencies were previously welcomed by policy makers because they helped to boost exports amidst what was a very weak economic backdrop. But now elevated inflation has changed this dynamic and weaker foreign currencies help fuel inflation fires abroad even further.
In addition, for a US based investor, weaker foreign currencies drag an international equity returns once back in US dollars, and they've subtracted nearly nine percentage points this year. So a more stable and actually preferably weaker dollar will be very welcomed by investors. But when will it peak?
Looking at the drivers of the dollar, there were two main phases this year. The first was March and April when the dollar rallied 6.4%. This part can be explained by widening interest rate differentials between US treasuries and other developed market government bonds, which widened 51 basis points just those two months. That was because investors sharply moved up expectations for fed rate hikes this year, but didn't move up expectations for the Bank of England, the ECB, and the Bank of Japan.
The second phase was the summer, June, July, August when the dollar rallied 6.7%. But this move cannot be explained by interest rate differentials, which were unchanged during that time period. As expectations for rate hikes by the fed were also met by more expectations by the Bank of England and the ECB. So it really seems like it was about global growth fears that took the front seat during the second leg.
That was because concerns were building about the energy crisis in Europe and the effect of zero covid in China fueling a flight of capital back to the safety of US assets. So in the short term, the dollar peak may be delayed while investors still wrestle with global recession fears and that can keep volatility elevated across assets and can continue dragging on international equity returns.
But in the timeframe of the next few quarters, it really seems like investor sentiments already quite depressed about foreign global growth. So any kind of incremental less bad news can fuel a rally in these depressed currencies.
So gravity will likely take its toll on the dollar, again, helping to calm asset markets and boosting international equity returns. And as we've argued previously, investors should continue thinking about allocating to international equities on an unhedged basis in order to potentially benefit from a future currency boost, and most importantly, to maximize the diversification benefit of this asset class.
After 15 years of steady appreciation against foreign currencies, the U.S. dollar already came into this year overvalued. Despite this, it has rallied a further 13% year-to-date to a 20-year high. This strength presents a mixed backdrop for the U.S. economy by dampening inflation, but dragging on real economic growth due to a widening trade deficit. For U.S. investors, the currency strength exacerbates concerns about S&P 500 earnings growth and acts as a drag on international equity returns. Globally, weaker currencies are no longer seen as a positive as it fuels inflation concerns. As a result, investors around the world would now welcome a weaker U.S. dollar - but when will the U.S. dollar peak? A mix of stabilizing interest rate differentials between the U.S. and developed markets, combined with more confidence around global growth, is needed. This is unlikely in the very short-term, but gravity seems likely to exert downward pressure on the dollar sooner rather than later.
At first glance, a “strong U.S. dollar” may seem like a positive. There are advantages: overseas trips are cheaper for U.S. tourists and foreign goods are cheaper to import for U.S. companies and consumers (helping bring down elevated inflation). However, important disadvantages exist: U.S. exports are more expensive for foreigners and foreign earnings of U.S. companies are dragged lower. In fact, net trade was a large drag on first quarter GDP (subtracting 323bps from growth) and U.S. companies cited the dollar strength as a headwind to second quarter earnings (this year’s 15% year-over-year dollar appreciation may shave 0.60 USD off S&P 500 operating earnings per share). Both are unwelcomed developments given concerns about recession risk and elevated earnings expectations. Globally, “weak currencies” were previously welcomed by policy makers, helping to boost exports amidst weak economic growth. However, elevated inflation has changed this dynamic, with weaker currencies fueling the inflationary fire further. In addition, for U.S.-based investors, weaker foreign currencies drag on international equity returns (with the currency subtracting nearly 9 percentage points this year).
A more stable (and preferably weaker dollar) would be welcomed by investors – but when will the dollar peak? Looking at dollar drivers, there have been two main phases of dollar strength this year:
- March and April when the dollar rallied 6.4%. This move can be explained by widening interest rate differentials between U.S. Treasuries and other developed market government bonds (which widened 51bps then). Investors sharply moved up expectations for Fed rate hikes (in February, three 25bps hikes were expected this year vs. eleven in April), while expectations for the Bank of England (BoE), European Central Bank (ECB) and Bank of Japan (BoJ) lagged far behind.
- Summer (June, July and August) when the dollar rallied 6.7%. This move cannot be explained by interest rate differentials which were unchanged during that time period, as expectations for rate hikes by the BoE and ECB moved up in tandem with the Fed (the BoJ is an exception). Global growth fears seem to have taken the front seat, especially as concerns about the energy crisis in Europe and “zero COVID” in China built, fueling capital flows back to the safety of U.S. assets.
In the short-term, the dollar peak may be delayed as investors still wrestle with global recession fears, keeping volatility elevated across assets and dragging on international equity returns. However, in the time frame of the next few quarters, investor sentiment about global growth has already gotten so depressed that “less bad” news can fuel a turnaround in foreign currencies. As gravity takes its toll on the U.S. dollar again, market volatility can decline and international equity returns can receive a boost. As we argued previously, investors should continue thinking about allocating to international equities on an unhedged basis in order to potentially benefit from the currency boost – and, crucially, to maximize the diversification benefits of the asset class.
Interest rate differentials explain only part of the story of U.S. dollar moves
Nominal trade weighted U.S. dollar index (major currencies) and U.S. 10-year yield minus DM 10-year yields*
Source: FactSet, Federal Reserve, Tullett Prebon, J.P. Morgan Asset Management.
*Nominal trade weighted index (major currencies) includes Australia, Canada, Europe, Japan, Sweden, Switzerland and UK. Interest rate differential is the difference between the 10-year U.S. Treasury yield and a basket of the 10-year yields of each of the seven major currencies. Weights on the basket are calculated using the 10-year average of total government bonds outstanding in each region. Europe is defined as the 19 countries in the euro area.
Data are as of September 13, 2022.
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