What’s behind U.S. dollar weakness?

Fed and global central banks on different tracks

Last week was an important one for markets. The U.S. Consumer Price Index (CPI) print showed that inflation, both headline and core, was lower than expected for June. This helped confirm our view that the U.S. is in the midst of a strong disinflationary trend. The journey is imperfect, but it’s happening.

There was a strong reaction to the CPI print, as markets anticipated that the end of the U.S. Federal Reserve’s (Fed) tightening cycle is near. Global equities rose, global yields fell, and the U.S. dollar fell significantly. In fact, the U.S. Dollar Index fell to a level it hasn’t seen since April 2022 when the Fed was just beginning its aggressive tightening cycle.

Global central banks and U.S. Fed on different tracks

As we have seen inflation peak in the U.S., we may also be past the peak of the U.S. dollar. The U.S. dollar is weakening as other currencies are strengthening because other economies’ central banks, especially the Bank of England but also the European Central Bank (ECB), have further to go than the Fed in terms of tightening – as I mentioned last week. That sets us up for an environment in which there is greater differentiation in the near term regarding monetary policy and the economic environment of major economies.

With inflation far more problematic in the UK, the U.S. is clearly in a very different place when it comes to anticipated monetary policy. This is also true in the eurozone, though to a lesser extent than the UK. The euro has also gained ground against the dollar recently. Although inflation isn’t as much of a problem in the eurozone as in the UK, the ECB likely still has more work to do than the Fed.

Thus, it’s no accident that as the dollar depreciates, it’s other major currencies that have been rallying. These are the currencies against which the dollar gained the most ground as the Fed became the most aggressive in tightening compared to other major central banks in 2022.

Recent currency moves are telling us that Japan is also in a different place than the U.S. Surprisingly, the Japanese yen appreciated sharply against the U.S. dollar over the past 10 days. The appreciation has been driven by a growing expectation that the Bank of Japan (BOJ) will substantially alter its current yield curve control policy – widely viewed as the first step in a BOJ tightening cycle – at its next monetary policy meeting in late July. The expectation seems to have been triggered by two factors: a recent rise in Japan’s 10-year breakeven inflation rate, and an expectation that the BOJ will upwardly revise its inflation outlook for fiscal years 2024 and 2025 at its next meeting. This appreciation of the yen relative to the U.S. dollar is obviously not just about Japan; it’s also about the drop in the dollar thanks to the lower-than-expected inflation data.

What drives dollar strength?

Economics textbooks have long explained that a whole host of factors impact the relative strength of currencies. However, over time I have learned that the most important factors dictating U.S. dollar strength are relative growth, rate differentials, and demand for the U.S. dollar as a “safe haven” asset.

The recent drop in the U.S. dollar largely reflects an expected end to Fed tightening in the near term as well as improving growth expectations (i.e., a growing consensus that the U.S. will avoid a hard landing). In addition, with market sentiment more bullish and the VIX volatility index at relatively low levels, there is little demand for a “safe haven” asset such as the U.S. dollar.

U.S. dollar: Still the dominant global reserve currency?

It's worth noting that the U.S. dollar’s status as the preeminent “safe haven” asset among currencies is at least partially derived from its status as the dominant global reserve currency. That status has come into question in recent years, and it’s a question I’ve received a lot lately given the recent emergence of challenges to U.S. dollar dominance in trade and payments in the face of U.S.-imposed economic sanctions.

The biggest recent challenge has been “petroyuan” – using Chinese yuan to settle crude oil trades, which enables countries to circumvent the U.S. in oil transactions. It’s a term derived from the “petrodollars” that were born in the 1970s when Saudi Arabia and other oil-exporting nations agreed to price their exports in U.S. dollars.

When considering this issue, I like to take a historical perspective. De-dollarization of the international system has been discussed for decades but has yet to happen. The Japanese yen and the euro were both considered major challengers to dollar dominance of the global financial system in the 1980s and the 2000s, respectively, but it never came to fruition. Having said that, today de-dollarization is about geopolitics and sovereignty, not macro/financial competition. And it’s driven by a national security imperative: many governments feel an urgent need to reduce exposure to U.S./Western financial sanctions, exclusion from the international payment system or, in a potential worst case, reserve freezes and seizures.

Whatever the drivers, historically the decline of a dominant global reserve currency has occurred over the course of decades rather than months. What’s more, we’re seeing attention being given to this topic – and measures being proposed to maintain U.S. dollar dominance – as U.S. policymakers recognize the benefits the American economy enjoys because of the dollar’s global reserve status.

Recently, the U.S. House Financial Services Committee held a hearing entitled “Dollar Dominance: Preserving the U.S. Dollar’s Status as the Global Reserve Currency.” This followed the introduction of a bill earlier this year that would require the U.S. Treasury Secretary to create a dollar strategy. Whether such legislation can get passed, let alone be successful in achieving long-term goals, remains to be seen. However, I do believe creating a dollar strategy would be a step in the right direction. For now, and for years to come, I anticipate the U.S. dollar will remain the dominant global reserve currency.

More dollar weakness expected

As we look ahead, I anticipate the U.S. dollar will continue to weaken as more signs point to Fed dovishness relative to other central banks, especially the Bank of England and, to a lesser extent, the ECB. The Bank of Japan is a slightly different situation. I am more skeptical about the BOJ altering its monetary policy in the near term as Japan’s export environment remains quite challenging, which should prevent the BOJ from tightening its policy prematurely.

The key takeaway is that the U.S. dollar is likely to continue weakening in the near term, and that has implications for earnings, trade and even asset performance:

U.S. companies that derive a large portion of their revenues from abroad stand to benefit from dollar weakening, which makes their products cheaper to foreign buyers. The U.S. tech sector, which derives a substantial portion of its revenue from outside the U.S., in particular could benefit from this.
Another potential beneficiary is emerging markets, given that U.S. dollar-denominated EM debt becomes less onerous to service when the dollar is weaker.

In short, recent currency moves are a reminder that investment opportunities can arise in many different ways.

Kristina Hooper is Chief Global Market Strategist at Invesco. With contributions from Tomo Kinoshita and Arnab Das.

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The opinions referenced above are those of the author as of July 17, 2023. These comments should not be construed as recommendations, but as an illustration of broader themes. This does not constitute a recommendation of any investment strategy or product for a particular investor. Investors should consult a financial professional before making any investment decisions.

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