Where Is the U.S. Dollar Headed?

Expectations of "higher for longer" U.S. interest rates has helped drive the dollar's recent rally.

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The U.S. dollar has surged in recent months, gaining more than 6% relative to the currencies of other major trading partners since mid-July. The rally has reversed the dollar’s decline from the start of the year and ran contrary to consensus expectations.

Figure 1: The dollar has risen in recent months. Chart shows the Bloomberg Dollar Spot Index movements year to date. As of September 28, the index level was 1267, up from1200 on July 13.  

Source: Bloomberg. Daily data as of 9/28/2023.

Bloomberg Dollar Spot Index(BBDXY Index). The Bloomberg Dollar Spot Index tracks the performance of a basket of 10 leading global currencies versus the U.S. dollar. Past performance is no guarantee of future results.

The major reason for the dollar’s recent rally has been the upward shift in expectations about the path of U.S. interest rates. At the start of the year, it appeared that the Federal Reserve would end its rate hikes mid-year and then begin lowering rates in late 2023 or early 2024. At the same time, central banks in other major countries were seen continuing their rate hiking cycles. Those expectations have changed due to the surprising resiliency of the U.S. economy and persistence of inflation pressures.

Consequently, the difference in interest rates between the U.S. and other major countries reversed the declining trend in July and started moving sharply higher, propelling the rebound in the dollar. All else being equal, higher interest rates make a currency more attractive to hold.

Figure 2: U.S. dollar vs U.S. interest rate differentials. Chart shows the Bloomberg Dollar Spot Index dating back to September 2022. It also shows the Bloomberg US Aggregate Bond Index minus the Bloomberg Global Aggregate ex-USD Index, which represents the yield advantage that U.S. interest rates offer relative to average global interest rates, dating back to September 2022. Historically, the dollar index has risen at roughly the same time as U.S. interest rates.  

Source: Bloomberg, daily data as of 9/27/2023.

Bloomberg Dollar Spot Index (BBDXY Index). Bloomberg US Aggregate Bond Index (LBUSYW Index) minus the Bloomberg Global Aggregate ex-USD Index (LG38STAT Index) which represents the yield advantage that U.S. interest rates offer relative to average global interest rates, dating back to September 2022. Past performance is no guarantee of future results.

The dollar has also benefited from strong foreign direct investment inflows, largely from close trading partners. Investment in manufacturing facilities has accounted for much of the increase as companies shift production to the U.S. market amid trade disputes. 

Figure 3: Foreign direct investment in the U.S. has risen. Chart shows the level of foreign direct investment in the U.S. dating back to 2000. It also shows shaded bars representing recessions. As of the second quarter of 2023, foreign direct investment in the U.S. was $74.6 billion.

Source: Bureau of Economic Analysis. Quarterly data as of Q2 2023.

BEA Foreign Direct Investment in the U.S., Total Country & Industry Detail for Income. Shaded bars indicate past recessions. Foreign direct investment (FDI) is the category of international investment that tracks resident entities in one country obtaining a lasting interest in enterprises from another country.

In contrast to the resiliency of the U.S. economy, growth in Europe and China has been weaker than expected. Germany, Europe’s largest economy, has fallen into recession and China’s growth has been held back by high debt levels in the property sector and a slow emergence from COVID-19 lockdowns.

The Japanese yen has also been weaker than anticipated. Coming into the year, it looked like rising inflation would lead the Bank of Japan to allow interest rates to rise from the zero bound that has prevailed for years, and even exit its “yield curve control” policy. However, the signals from the Bank of Japan have been mixed. Bond yields have moved up, but it’s still retaining the yield curve control policy which limits the upside. Consequently, since the Bank of Japan stepped in to cap rising yields, the Japanese yen has fallen back toward levels last seen in the late 1990s. 

Figure 4: The dollar has risen against the Japanese yen. Chart shows the price of one U.S. dollar in Japanese yen dating back to 1995. As of September 28, 2023, the dollar was worth 149.4 yen, the weakest level for the yen since the 1990s. 

Source: Bloomberg, daily data as 9/28/2023.  

Spot Exchange Rate: Price of 1 USD in JPY (USD JPY BNG CURNCY). Past performance is no guarantee of future results. For illustrative purposes only.

Emerging market (EM) currencies have also dropped versus the dollar in recent months. In this interest rate cycle, EM countries have tended to lead by hiking rates earlier than the major developed country central banks, which helped support some EM currencies. Lately however, there have been a handful of rate cuts by EM central banks. It’s a diverse set of countries with huge differences. Those countries that have borrowed in U.S. dollars are the most vulnerable to the combination of rising interest rates and a strong dollar. 

Figure 5: EM currencies have dropped vs the dollar in recent months. Chart shows emerging market currencies that have declined against the U.S. dollar between July 14, 2022, and September 28, 2023. These range from the Columbian peso, which is down 0.1% versus the dollar, to the Argentine peso, which is down 24.3% versus the dollar. 

Source: Bloomberg. World Currency Ranker (WCRS) Spot Returns. Date range 7/14/2022 to 9/28/2023.
 
Past performance is no guarantee of future results. For illustrative purposes only.

Overall, the dollar’s strength is likely to continue until there are signs that the Federal Reserve is poised to shift from its tight monetary policy stance to easing. We don’t expect the dollar to go back to last year’s peak. However, it is likely to remain in an uptrend until the underlying fundamental factors propelling it higher change.

For U.S. dollar-based investors, it is challenging to make the case for a significant allocation to foreign bonds given the wide interest rate differentials. Moreover, the correlation between U.S. and foreign bonds is very high. In the past, the correlation has declined during recessions or downturns in the global economy with EM bonds offering the greatest diversification from U.S. bonds. However, EM bonds tend to be far more volatile and may not be appropriate for many investors. For now, investors may want to consider limiting allocation to foreign bonds until there is a better opportunity. 

Figure 6: U.S. and foreign bonds tend to move in similar directions. Chart shows the 52-week rolling correlation between the Bloomberg US Aggregate Bond Index and the Bloomberg Global Aggregate ex-USD Index, as well as the correlation between the Bloomberg Emerging Market Aggregate Bond Index and the Bloomberg US Aggregate Bond Index.  

Source: Bloomberg, using weekly data from 4/2/2004 through 9/29/2023.

Bloomberg U.S. Aggregate Bond Index (LBUSTRUU Index), Bloomberg Global Aggregate ex-USD Bond Index (LG38TRUU Index), Bloomberg Emerging Markets USD Aggregate Bond Index (EMUSTRUU Index). Correlation is a statistical measure of how two investments have historically moved in relation to each other, and ranges from -1 to +1. A correlation of 1 indicates a perfect positive correlation, while a correlation of -1 indicates a perfect negative correlation. A correlation of zero means the assets are not correlated. Past performance is no guarantee of future results.

In the past, the correlation has declined during recessions or downturns in the global economy with EM bonds offering the greatest diversification from U.S. bonds. However, EM bonds tend to be far more volatile and may not be appropriate for many investors. For now, investors may want to consider limiting allocation to foreign bonds until there is a better opportunity. 

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