The Dollar Could Bring a Nasty Surprise to Investors

Today’s exchange rates are mostly floating, determined by the market rather than crunch negotiations. Yet once again the weak dollar has breathed a sigh of relief. Last September, the DXY, a measure of the dollar’s strength against other currencies, was at its highest level in 20 years (see chart). The yen had fallen; The pound at one point looked like it was racing towards parity with the dollar; The euro spent brief periods below it. Since then, the greenback has weakened: as measured by the dxy, it is now down 10% from its recent peak.

A mighty dollar doesn’t put an end to the problems. Poor countries borrow in currency. When it is strong, these loans become huge. Even in rich countries, where governments mostly issue debt in their own currency, a strong dollar squeezes corporate borrowers. A 2020 analysis by three economists, Matteo Maggiori, Brent Niemann and Jesse Schrager, showed that more than 90% of corporate bonds held by foreigners in Australia, Canada and New Zealand were denominated in foreign currencies, usually the dollar.

It is not only the debtors who are suffering. Commodity prices are quoted in dollars; They get expensive when the currency strengthens. American exporters become less competitive because their products are more expensive for foreigners. The returns of American investors with foreign assets have been eaten up. So, there’s good reason to cheer in the greenback’s retreat.

Unfortunately, the relief may be temporary. To see this, consider the sources of the dollar’s recent strength. One is monetary policy. Throughout 2022, the US Federal Reserve raised rates higher and faster than other central banks. This made the dollar a good target for a “carry trade”: selling a lower-yielding currency to buy a higher-yielding currency and pocketing the difference. Another source is fear. Russia’s invasion of Ukraine, China’s unsettling “zero-Covid” policy and the global economy teetering towards recession raised the anxiety level of the markets. In troubled times, investors reach for the perceived safety of American assets. A final source is the US economy. Partly due to high energy prices and the country’s status as an energy exporter, it appears to be in a better position than the rest of the world.

True, the Fed’s pace of tightening is slowing, and its governors expect rates to rise this year. But they expect the peak to be more than 5% higher than investors expected, and to be sustained for a long time before being cut. If the market accepts the central bank’s view, there could be another phase of carry trade. Fear can also be business, depending on the progress of an unexpected war.

Even a US recession cannot affect the dollar. The greenback does well when the US economy is booming and falls into recession, a phenomenon currency traders refer to as the “dollar smile”. Increasing the appeal of dollar assets as a haven.

Yet the best argument for a stronger dollar is investors’ belief that this will not happen. In a recent survey of fund managers by Bank of America, a near-record proportion thought the greenback would weaken. Among forecasters surveyed by data provider Bloomberg, the average forecast is for the dollar to fall against every other major currency this year and continue to decline thereafter.

With $6.6 trillion traded against other currencies every day, it’s hard to imagine that at least some of these bets haven’t already been placed. The higher it is, the higher the potential for growth. Immediately after the Smithsonian Agreement, speculators threw currency markets back into chaos by forcing the dollar to further devalue, eventually breaking down the Bretton Woods system altogether. Nowadays, the biggest pain would be if the dollar were to move in the opposite direction. Investors may be in for a shock.

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