2022 is shaping up to be a historic year for markets. But while the S&P 500 is heading for its worst first half since 1970, the dollar appreciated during the first six months of 2022 by the largest margin in history, according to some measures.
The Federal Reserve’s decision to raise interest rates by 75 basis points in June in pursuit of what Capital Economics describes as the most aggressive monetary tightening since the 1980s has caused the USDJPY green dollar.
to increase by 17% against the Japanese yen during the first half of the year. This is the largest move of the dollar against the yen in history, according to Dow Jones Market Data, based on figures dating back to the early 1950s.
Against the euro EURUSD,
the other major rival of the dollar, the dollar has risen more than 7% since the beginning of the year, its strongest yield in the first half since 2015, when an economic crisis in Greece allayed fears about the possible collapse of the eurozone.
And by measuring the strength of the dollar more broadly, the WSJ Dollar Index, BUXX,
which incorporates 16 rival currencies in its calculation of the value of the dollar, has increased by 8% so far this year, on the way to its greater appreciation in the first half since 2010.
In the forex market, where intraday movements are usually measured in basis points, macro strategists told MarketWatch that movements of this magnitude are more typical of emerging market currencies, not G-10 currencies like the US dollar.
But why is the dollar rising so aggressively? And what does the strength of the dollar mean for stocks and bonds when the second half of 2022 begins?
What raises the dollar?
With inflation at its most intense level in 40 years, the dollar has benefited from two headwinds this year.
The most important, according to a handful of currency strategists on Wall Street, is widening the spread between interest rates in the US and the rest of the world. Dozens of other central banks (including the European Central Bank) have decided to follow in the Fed’s footsteps by raising or planning to raise interest rates. However, real interest rates in the US, i.e. the rate of return on bonds and bank deposits when adjusted for inflation, remain more attractive, especially compared to Europe, where inflationary pressures have been more intense, and the European Central Bank recently. presented its plan to embark on interest rate hikes from July.
In Japan, where inflationary pressures are most moderate, the Bank of Japan has resisted the global monetary tightening trend and has continued its policy of controlling the yield curve by buying large amounts of government bonds. Japanese government.
But a favorable interest rate differential is not the only factor driving the dollar up: the dollar has also benefited from the newly acquired “safe haven” status.
According to a model developed by Steven Englander, global head of G-10 currency strategy at Standard Chartered Bank, 55% of the dollar’s appreciation this year has been driven by interest rate differentials (and, most importantly, , expectations around the monetary trajectory). US policy in relation to other developed nations), while the other 45% has been driven by safe haven flows.
Englander and his team developed the model by comparing dollar yields with simultaneous movements in U.S. Treasury yields and stocks.
“Since mid-March, the most reliable indicator of the strength of the USD has been the rise of spreads and the fall of the S&P,” Englander wrote in a recent research note presenting his model.
The S&P 500 SPX,
it has fallen a lot. It has fallen nearly 20% during the year to date until Wednesday, on the way to its worst performance in the first half since 1970, according to Dow Jones Market Data. The Dow Jones Industrial Average DJIA,
it fell 14.6% in the same stretch, its worst performance since 2008.
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And investors have not found security in government bonds, with Treasury yields moving opposite the price, rising sharply as the Fed moves forward to aggressively tighten monetary policy.
I will see: The major bond ETFs paced during the worst first half of a recorded year
But even when stocks have fallen and bonds have recovered (bond prices move in the opposite direction to yields), the dollar, most of the time, has continued to appreciate. The pattern is clear: since the beginning of the year, when markets have turned against risk, the dollar has benefited.
“This may be because when the appetite for risk, for example, due to the war between Russia and Ukraine, is pushing the USD, there is a tendency for both U.S. and foreign rates to move in the same direction. As a result, it may be ambiguous if the spread increases or decreases, but it is very likely that the USD will respond to the risk movement rather than the spreads, ”Englander said.
Historically speaking, this type of negotiation pattern is anomalous, and whether it persists into the second half of the year is open to debate. With the Federal Reserve insisting on reacting to the evolution of growth and inflation as the data arrives, expectations around Fed plans will continue to change in the fall, said Marvin Loh, a macro strategist. State Street senior global strategist.
“Right now we are setting prices [with Fed rate hikes] in the next 9 or 12 months. If you don’t, you’ll get a continuation of the story, ”Loh said.
Over the past week or so, derivatives market movements suggest investors are beginning to guess whether the Fed will continue with at least 350 basis points of interest rate hikes this year. The central bank has already raised the top band of its Fed fund target rate to 1.75%, and according to the Fed’s latest “point chart” released in June, the forecast is “median” calls for a target rate of between 3.50% and 3.75% next year.
Reads: A “pinch” for the stock market, but good news for the Fed: what investors should know about a strong US dollar
However, the futures of Fed funds, a derivative used by investors to bet on the direction of the benchmark interest rate, began trading at a rate cut in July 2023.
A recent decline in the price of crude oil CL00,
and other commodities — industrial metals and even wheat have seen prices fall sharply — have helped to ease inflation expectations somewhat. But if inflation persists for longer than expected, or if the U.S. economy resists falling into a recession, expectations about the pace of Fed rate hikes could change again.
Then, as other central banks strive to catch up with the Fed – 41 of the 50 central banks covered by Capital Economics have raised interest rates so far this year – it seems increasingly likely the interest rate differential between the Fed and its rival. central banks could begin to retreat.
As for other central banks, perhaps the biggest question on this front is whether the Bank of Japan and the People’s Bank of China could abandon their easy monetary positions.
Neil Shearing, chief economist at the Capital Economics group, recently suggested that the BoJ is more vulnerable to a capitulation in the realm of monetary policy than the PBOC.
At this rate, if the BoJ continues to buy bonds to defend its limit on JGB yields, it will own the entire Japanese government bond market (one of the largest sovereign bond markets in the world in terms of total issuance) in a year, Shearing said. .
Consequences of a stronger dollar
But there are also many national factors that could influence the direction of the dollar. As inflation persists and the US economy begins to slow: the “flash” reading of the global S&P Purchasing Managers Index in June showed that economic output is slowing to its level. weaker since the January micron-driven slowdown – it’s important to remember that the macroeconomic environment looked very different just a few years ago.
During the 2010s, central banks around the world aimed to keep their currencies weak to make their exports more competitive while importing a measure of inflation.
Now, the world has entered a period of what Steven Barrow, head of G-10 strategy at Standard Ban, calls a “reverse currency war.” Today, a strong currency is more desirable because it acts as a buffer against inflation.
Because it is the world’s reserve currency, the strong U.S. dollar is a problem for both developed and emerging economies. While the U.S. economy is relatively isolated from financial tensions caused by a strong dollar, if its strength persists, Barrow worries that other economies may face “some unpleasant problems,” including the exacerbation of inflationary pressures or possible monetary crises such as the one that affected East Asia. and Southeast Asia in 1997.
But will the strength of the dollar last during the second half of the year? On this, analysts and economists are divided. Jonathan Petersen, market economist at Capital Economics, said he believes the slowdown in the global economy means the dollar probably has more room to move forward, especially after its latest setback.
Instead, Englander sees the dollar recover some of its gains during the second half of the year.
Suspicious that a rise in risk appetite could push up the S&P 500 during the second half of the year, while reversing “safe haven” flows and a reduction in the interest rate differential could conspire to lower part of the strength of the dollar.
However, an outburst of “earnings pessimism” driven by a falling US recession economy could weigh on stocks and strengthen the dollar, while a “soft landing” like the one the Federal Reserve seeks could provide a cushion for actions and cause a certain setback. in the dollar.