Could Resurgent Interest Rate Differentials Send the Dollar Higher?
One prominent story of 2022 was the strong U.S. Dollar (DXY), which rallied 8.15% versus a basket of other global currencies, according to Bloomberg Terminal data – but at one point had appreciated up to approximately 20%. Accelerating inflation in the United States starting in late 2021 set a vigilantly hawkish Federal Reserve on an aggressive path of rate hikes starting in early 2022, while a lagging hawkish response by other global central banks opened up a substantial interest rate differential between the United States’ and other countries’ currencies. Compounding the interest rate driver for the Dollar’s appreciation were geopolitical risk flight from the Euro as the Russia-Ukraine War interrupted energy markets and the Bank of Japan’s Yield Curve Control (YCC) policy which pushed the Japanese Yen down approximately 12% to a multi-decade low against the Dollar.
Some of the noteworthy effects of a stronger Dollar are weakened profits for U.S. companies receiving substantial international revenues (as their revenues in other currencies convert to relatively fewer dollars) as well as downward pressures on commodity prices as most are priced in dollars.
These may be among the reasons why the recent decline in the U.S. Dollar basket – down roughly 9% since peaking in September – has stoked optimism about easing pressures on multinational corporations and even fresh bull trends for commodity-based stocks, particularly precious metals and commodities that may benefit from China’s post-Covid Zero policy reopening. The VanEck Gold Miners ETF (NYSEArca: GDX) has consequently risen nearly 40% as of January 3 since bottoming in September (three days before the dollar basket topped). Freeport-McMoRan (NYSE: FCX), a bellwether with over 100 billion pounds of proven copper reserves, has seen its stock celebrate Dollar weakness with an approximate 45% rally as of January 3 since bottoming in September.
But could the Dollar see another spurt of strength? Under one conceivable scenario, the U.S. Federal Reserve’s clearly telegraphed “higher for longer” path for interest rates could coincide with more rapid and deeper economic woes throughout Europe and emerging markets in Asia that force other global central banks off their rate path. This dynamic could reinstitute the interest rate differential, strengthening the Dollar against other major currencies. Interest rate hikes by the European Central Bank are raising borrowing costs for already strained fiscal budgets throughout Europe, with Italy and Spain appearing the most vulnerable. While the United States may have the economic fortitude to pursue an anti-inflationary “higher for longer” policy, Europe may not be able to get away with its fiscal excesses. And while Japan has relaxed the upper bound of their 10-year interest rate target within their Yield Curve Control policy, it has quickly – and perhaps prematurely – become widely believed that the Bank of Japan is on a path to more policy normalization, strengthening the Yen. But with Governor of the Bank of Japan Haruhiko Kuroda’s term coming to an end in April 2023, it may be too speculative to factor in a decisive view on the path of Japanese policy into U.S. currency movements. With the potential that the global economy could enter a prolonged slowdown, betting on anything other than more gradual tightening in monetary policy from Japan, a substantial export economy, may lead to an undue Yen rally.
In the long term, the United States’ seemingly unsustainable budget deficits and large trade deficits may conspire to lead the Dollar into a bearish trend. But the recent quarter of unwinding trades in global currencies may be more a matter of positioning than a true turning point in macro fundamentals. With the chorus for a lower Dollar – and higher global currencies – growing, investors in metals and mining and other companies sensitive to currency movements must maintain situational awareness regarding intermediate risk-reward.
