Oyour currency, your problem. This is how John Connally, America’s Treasury Secretary, described the dollar to European leaders in 1971. The wording was apt. His boss Richard Nixon had suspended the convertibility of the dollar into gold and called for a change in the exchange rate system introduced at Bretton Woods in 1944. Other countries were told to strengthen their currencies or America would impose trade restrictions on them. Conformity soon followed. By the end of the year, the Smithsonian Agreement had devalued the dollar by around a tenth against major foreign currencies.
Today’s exchange rates are mostly free floating and are set by the market rather than crunch talks. But once again a weaker dollar provides 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 headed for parity with the dollar; The euro underperformed for a few brief periods. Since then, the greenback has weakened: measured on dxyit is now 10% below its recent peak.
A mighty dollar causes endless problems. Poorer countries tend to borrow in the currency. As it gets stronger, that debt gets stronger. Even in rich countries where governments mostly issue bonds in their own currency, a stronger dollar weighs on corporate borrowers. A 2020 analysis by economists Matteo Maggiori, Brent Neiman and Jesse Schreger showed that in Australia, Canada and New Zealand, more than 90% of foreign-held corporate bonds are denominated in foreign currencies, typically dollars.
Not only the debtors suffer. Commodity prices are in dollars; as the currency strengthens, they become more expensive. American exporters are becoming less competitive as their products are more expensive to foreigners. American investors with overseas assets are having their returns eaten away. Good reason, then, to celebrate the dollar’s retreat.
Unfortunately, the relief can be temporary. To see why, consider the sources of the dollar’s recent strength. One of them is monetary policy. Throughout 2022, the US Federal Reserve raised interest rates more and faster than other central banks. This made the dollar a good target for a carry trade: selling a low-yielding currency to buy a high-yielding currency and raking in the difference. A second source is fear. Russia’s invasion of Ukraine, China’s unsustainable “zero Covid” policy and the global economy’s slide towards recession have heightened market concerns. In troubled times, investors tend to reach for the perceived safety of American assets. A final source is the American economy. Partly due to higher energy prices and the country’s status as an energy exporter, it appears to be in better shape than the rest of the world.
True, the Fed’s pace of tightening is slowing and its governors expect rates to peak this year. But they expect that peak to be higher than investors at over 5% and that it will be sustained longer before being lowered. If the market accepted the central bank’s view, the carry trade could have another foothold. So does the fear trade, which depends on the course of an unpredictable war.
Even an American recession cannot affect the dollar. The greenback tends to perform well both when the US economy is advancing and when it is in a downturn, a phenomenon currency traders call the “dollar smile.” If American growth falters, the global economy is also likely to be in jeopardy, increasing the attractiveness of dollar assets as safe havens.
But the best argument for the dollar strengthening is investor belief that it won’t. In Bank of America’s most recent survey of fund managers, nearly a record proportion believed the greenback would weaken. Among forecasters polled by Bloomberg, a data provider, the median expects the dollar to fall against all other major currencies this year and continue to fall thereafter.
With roughly $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 more that have, the greater the potential for advancement. Shortly after the Smithsonian Accords were signed, speculators wreaked havoc on the foreign exchange markets again, forcing the dollar to depreciate further and eventually collapsing the Bretton Woods system. Today the biggest pain would come if the dollar were pushed in the opposite direction. Investors could be in for a shock.
Read more from Buttonwood, our financial markets columnist:
Will 2023 be another terrible year for investors? (January 5th)
India’s stock markets are booming. They also have serious flaws (20th of December)
For bond investors today, every country is an emerging market (December 8)
Sign up for more expert analysis of the biggest stories in business, finance and markets talks about moneyour weekly newsletter for subscribers only.
