In focus

Why has the dollar been so strong – and can it continue?


To set the scene, let’s cast our minds back to March 2020. As Covid hit European shores and fears of complete economic shutdown jolted financial markets, we saw a scramble for US dollars, with all major currencies falling significantly against the greenback. But this short-lived appreciation in the value of the US dollar was to mark the currency’s peak for the next two years.

A robust response from central banks and governments caused real bond yields (yields net of inflation) to fall and growth and inflation expectations to rise. This was accompanied by much improved market sentiment, which is generally associated with reduced demand for US dollars. This environment lasted until the middle of 2021, when investors started to anticipate a return to a more conventional monetary policy regime. Economies were recovering from the pandemic and both inflation expectations and real bond yields were rising. The dollar started to regain ground against its major counterparts – the euro, yen and sterling – and sentiment towards the currency turned increasingly positive.

This move has been turbocharged in 2022 as the Federal Reserve has indicated that it will raise interest rates much more aggressively than markets were expecting at the start of the year. Sterling and the euro have weakened meaningfully, while traditional safe haven currencies such as the Swiss franc and the Japanese yen have also lost value as their central banks fail to keep pace with the Federal Reserve. By contrast, currencies of major commodity producers – such as Brazil and South Africa – have held up well, supported by higher commodity prices and improving terms of trade.

The Dollar Index has fully reversed its losses since peaking in March 2020

FX_chart1.jpg

Source: Refinitiv Datastream
Past performance is not a guide to future performance. The value of an investment and the income from it may go down as well as up and investors may not get back the amount originally invested.

This year's rise in US real interest rates, which are now higher than in other developed markets, has been a key factor supporting the dollar. The real yield on five-year US government debt remains slightly negative but currency markets tend to respond to changes, rather than absolute levels. Consequently, we have witnessed the broad USD index1 appreciate by more than 13% as the real yield on US inflation-linked government bonds2 has risen by 1.6 percentage points in the last year3. The real yields on German and British government debt remain deeply negative and have either fallen or risen only slightly during this period,4 hurting their respective currencies.

US dollar has risen in line with real rates …

US Dollar Index and US 5 Year “real” government yield

FX_chart2.png

Source: Refinitiv Datastream. 
Past performance is not a guide to future performance. The value of an investment and the income from it may go down as well as up and investors may not get back the amount originally invested.

Does fair value matter?

The increasingly global nature of capital markets, combined with greater mobility of private investors, means that cross-border investing today is the norm, not the exception. Exchange rate movements are an important risk to consider when investing in assets denominated in other currencies.

Like stocks and bonds, currencies have a “fair value” which acts as an anchor over the long term. But the “fair value” of a currency is not constant – it evolves over time, driven principally by two factors: real interest rates and inflation. Generally speaking, a country with persistently higher inflation and lower real interest rates sees the fair value of its currency depreciate over time. However, the premium or discount to “fair value” has little bearing on short term exchange rate movements, which are driven more by changes in interest rates, bond yields, overall risk appetite, sentiment and positioning. “Fair value” becomes more relevant at times of extreme distortion. When a currency has become too cheap or expensive, the risk of policy intervention goes up and that increases the risk of sharp moves in exchange rates.

Cazenove Capital’s Investment Committee looks at a number of measures on a regular basis to assess the “fair value” of key currencies that we have exposure to. The US dollar appears to be expensive on most measures, whereas sterling and the euro look somewhat cheap. The yen looks very cheap, while the renminbi has become expensive over the last few years against its key trading partners.

What’s the outlook?

Given the pace and extent of US dollar appreciation, we could well see sterling, the euro and other currencies enjoying a modest bounce against the greenback. However, we expect the current dynamics supporting the dollar to remain in play for some time. The US is relatively insulated from the uncertainty arising from the invasion of Ukraine. This may well mean that the US economy continues to outperform – and that headline US inflation starts to fall sooner than in the UK or Eurozone. With wages and rents still rising more quickly than the Fed would like, interest rates are still likely to rise. The combination suggests that real US rates will continue moving higher.

The most dramatic change to the outlook could come from a negotiated settlement between Russia and Ukraine, if it results in an easing of sanctions on Russian energy and food exports. This would see global inflation peak and boost confidence, both undermining the US dollar’s relative appeal. Sadly, this looks unlikely to materialize anytime soon given that neither side is in a position to claim it has achieved its minimum strategic goals.

We could also see a weakening of the dollar if US growth is weaker than expected or if it is slower than in other big economies. This would cause interest rate differentials to move against the dollar as the Fed pares back its hawkishness. There’s a caveat here, however. If the slowdown is bad enough that it leads to a recession, the US dollar could continue to strengthen as a result of safe-haven flows.

Our base case is that interest rate differentials will continue to drive exchange rates for the time being. Central banks that sound more “hawkish” will see their currencies appreciate – or at least prove more resilient.

What we are doing in portfolios

Within our sterling, multi-asset strategies, we currently have a slightly larger allocation to USD than suggested by our benchmarks – to the tune of approximately 6% across different risk mandates. This has helped performance in a more challenging year. This position increases the defensiveness of our portfolios and we are happy to stick with it for now.

This currency tailwind for sterling-based investors is more of a headwind for our US dollar portfolios. In our case, however, international exposure comes through holdings in renminbi and emerging market currencies, which have fared somewhat better than the sterling and the euro.

Market data suggests that many traders are now positioned for further rises in the dollar. This often happens when a trend is coming to at least a temporary pause. We think this may well be the case for the US dollar. However, given the many factors supporting the US currency, we do not expect to see a significant reversal of the trend.

For information purposes only and nothing in this article/on this slide should be deemed to constitute the provision of financial, investment or other professional advice in any way. You should seek professional advice for your individual circumstances.

ICE US Dollar Index (“Dollar Index”)
2 Real yield on the generic 5y US Treasury Inflation Protected Securities
3 Period from 31.05.21 – 31.05.22
4 Real yield on German inflation linked debt maturing in Apr ‘26 has fallen by 0.34% to -2.2%. Real yield on UK index linked Gilt maturing in Nov ’27 has risen by 0.1% to -2.85%

The opinions contained herein are those of the author and do not necessarily represent the house view. This document is intended to be for information purposes only. The material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The material is not intended to provide, and should not be relied on for, accounting, legal or tax advice, or investment recommendations. Information herein is believed to be reliable but Cazenove Capital does not warrant its completeness or accuracy. No responsibility can be accepted for errors of fact or opinion. This does not exclude or restrict any duty or liability that Cazenove Capital has to its customers under the Financial Services and Markets Act 2000 (as amended from time to time) or any other regulatory system. Cazenove Capital is part of the Schroder Group and a trading name of Schroder & Co. Registered Office at 1 London Wall Place, London EC2Y 5AU. Authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority. For your security, communications may be taped and monitored. 

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James Brennan

James Brennan

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