The US Dollar started 2022 with a 6-month rage — what this means for markets in the 2nd half

2022 promises to be a historic year for the markets. But as the S&P 500 heads for its worst first half since 1970, the dollar has appreciated in the first six months of 2022 by the largest margin in history, by some metrics.

The Federal Reserve’s decision to raise interest rates by 75 basis points in June in what Capital Economics describes as the most aggressive monetary tightening since the 1980s caused the dollar USDJPY,
+0.02%
rebound 17% against the Japanese yen in the first half of the year. It’s the biggest dollar move against the yen in history, according to Dow Jones Market Data, based on numbers dating back to the early 1950s.

Against the euro EURUSD,
,
Another main rival of the greenback, the dollar has risen more than 7% since the start of the year – its best performance in the first half since 2015, when an economic crisis in Greece fueled fears of a possible collapse. the euro zone.

And measuring the strength of the dollar more broadly, the WSJ Dollar Index, BUXX,
+0.02%
which factors 16 rival currencies into its calculation of the value of the dollar, has risen 8% so far this year, on track for its strongest first-half appreciation since 2010.

In the currency market, where intraday moves are typically measured in basis points, macro strategists told MarketWatch that moves of this magnitude are more typical of emerging market currencies, not G-10 currencies like the American dollar.

But why is the dollar rising so aggressively? And what does the strong dollar mean for stocks and bonds at the start of the second half of 2022?

What makes the dollar go up?

With inflation raging at its most intense level in 40 years, the dollar has benefited from two tailwinds this year.

Most important, according to a handful of Wall Street monetary strategists, is the growing gap between interest rates in the United States 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 United States – i.e. the rate of return on bonds and bank deposits adjusted for inflation – remain more attractive, especially compared to Europe. , where inflationary pressures have been more intense, and where the European Central Bank has only recently unveiled its plan to undertake interest rate hikes from July.

In Japan, where inflationary pressures are more subdued, the Bank of Japan resisted the global trend towards monetary tightening and continued its yield curve control policy by buying Japanese government bonds on a massive scale.

But a favorable interest rate differential is not the only factor pushing the dollar higher: the greenback has also benefited from a new “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, more importantly again, expectations surrounding the currency’s trajectory in the US relative to other developed countries) while the remaining 45% was driven by safe-haven flows.

Englander and his team developed the model by comparing the performance of the dollar to the simultaneous movements of Treasury and US stock yields.

“Since mid-March, the most reliable indicator of USD strength has been rising spreads and falling S&P,” Englander wrote in a recent research note outlining his model.

The S&P 500 SPX,
-0.07%
had a lot of falls. It is down nearly 20% year-to-date through Wednesday, on track for its worst first-half performance since 1970, according to Dow Jones Market Data. The Dow Jones Industrial Average DJIA,
+0.27%
was down 14.6% over the same period, its worst performance since 2008.

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And investors have found no safety in government bonds, with Treasury yields, which move opposite to price, rising sharply as the Fed moves to aggressively tighten monetary policy.

See: Major bond ETFs on pace with worst first half to year on record

But even when stocks fell and bonds rallied (bond prices move inversely to yields), the dollar has, more often than not, continued to appreciate. The trend is clear: since the start of the year, when markets became risk averse, the dollar has benefited.

“This may be because when risk appetite – for example, due to the Russian-Ukrainian war – is driving the USD, US and foreign rates tend to move in the same direction. As a result, it can be ambiguous whether the spread is going up or down, but the USD is very likely to react to risk movement rather than spreads,” Englander said.

Historically speaking, this type of trading pattern is anomalous, and its persistence in the second half of the year is debatable. While the Federal Reserve insists on reacting to the evolution of growth and inflation as the data comes in, expectations about the Fed’s plans will continue to change as we approach the fall, said Marvin Loh, global macro strategist at State Street.

“Right now, we’re evaluating being done [with Fed rate hikes] in the next 9 or 12 months. If not, you’ll get a sequel to the story,” Loh said.

Over the past week, movements in the derivatives markets suggest that investors are beginning to wonder whether the Fed will follow through with at least 350 basis points of interest rate hikes this year. The central bank has already raised the upper range of its target federal funds rate to 1.75%, and according to the latest Fed “dot plot” released in June, the “median” forecast calls for a target rate of between 3, 50% and 3.75% next year.

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However, federal funds futures, a derivative used by investors to bet on the direction of the benchmark interest rate, began pricing in a rate cut in July 2023.

A recent decline in the CL00 crude oil price,
-0.15%
and other commodities – industrial metals and even wheat saw their prices fall sharply – helped to temper inflation expectations somewhat. But if inflation were to persist longer than expected, or if the US economy weathered a recession, expectations surrounding the pace of Fed rate hikes could change again.

Then again, as other central banks scramble 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 looks increasingly likely that the differential of interest rates between the Fed and its rival central banks could begin to fall back.

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 accommodative monetary positions.

Neil Shearing, group chief economist at Capital Economics, suggested recently that the BoJ is more vulnerable to a capitulation on the monetary policy front than the PBOC.

At this rate, if the BoJ continues to buy bonds to defend its cap 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 emissions) within a year, Shearing said. .

Consequences of a stronger dollar

But there are also plenty of domestic factors that could influence the direction of the dollar. As inflation persists and the U.S. economy begins to slow – the S&P Global Composite Purchasing Managers’ ‘flash’ reading for June showed economic output slowing to its weakest level since the slowdown in the economy. January omicron – it is important to remember that the macroeconomic environment looked very different 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 as it acts as a buffer against inflation.

Because it is the world’s reserve currency, the strength of the US dollar is a problem for both developed and emerging economies. While the U.S. economy is relatively insulated from the financial strains caused by a strong dollar, if its strength persists, Barrow fears other economies could face “nasty problems,” including exacerbating inflationary pressures or crises. potential currencies like the one that shook East Asia. and Southeast Asia in 1997.

But will the strength of the dollar persist in the second half? On this, analysts and economists are divided. Jonathan Petersen, a market economist at Capital Economics, said he believed the slowing global economy meant the dollar likely had more room for improvement, especially after its latest pullback.

Englander, on the other hand, sees the dollar retrace some of its gains in the second half of the year.

He suspects a rebound in risk appetite could push the S&P 500 higher in the second half of the year, while reversal in “safe haven” flows and a narrowing of the interest rate differential interest could help undermine some of the dollar’s strength.

However, a spike in “earnings pessimism” driven by a US economy sliding into recession could weigh on stocks and support the dollar, while a “soft landing” like the one the Federal Reserve is aiming for could provide a cushion. for stocks while causing some retracement. in the dollar.

About Meredith Campagna

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