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Looser US monetary policy weakens the dollar

Autor: Article based upon analysis from Reuters Breakingviews
2 min

After dominating foreign exchange markets in 2021 and most of 2022, the dollar is now weakening due to less aggressive U.S. monetary policy.

The near-term outlook is difficult, especially against the euro, which is benefiting from a robust economy and a rigid central bank. Greenback fans should hope that a mild recession will help their preferred currency regain its historic role as a safe haven.

Between January 2021 and October 2022, the dollar gained more than 17% against a trade-weighted basket of currencies from the U.S.’s major trading partners, according to Federal Reserve data.

The U.S. currency rose due to global economic uncertainty and a central bank determined to fight inflation by raising interest rates starting in March 2022.

usd

The U.S. dollar has given up some of its gains against a trade-weighted basket of currencies. Source: Federal Reserve | Francesco Guerrera | Breakingviews | April 25, 2023

These driving forces are now fading. Domestically, the Fed is approaching the peak of interest rates.

According to derivatives prices tracked by Refinitiv, markets expect a final 25 basis point hike in May before rate cuts begin in November.

Internationally, Europe avoided a recession thanks to a mild winter that pushed down energy prices and China’s surprisingly strong recovery from Covid-19 isolation.

This resilience is keeping inflation high in the eurozone. The „core” inflation rate, which excludes food and energy, rose at a record annual rate of 7.5% in March, well above the 5.6% U.S. inflation rate.

As a result, the European Central Bank is likely to take a tougher stance than the Fed.

The markets expect the European Central Bank’s deposit rate to rise from the current 3% to 3.75% by July and to remain at this level for the rest of the year.

These factors explain the 14% rise in the common currency from 0.96 against the dollar at the end of September to 1.1 now, and a further rise is likely, with the euro targeting the 1.13 to 1.15 levels reached in early 2022.

In the long term, however, the dollar may benefit from a worsening economic outlook. According to Capital Economics, the dollar has appreciated in six of seven U.S. recessions since 1970.

This is due to the spillover effects of U.S. weakness to the rest of the world and investors’ preference to buy the dollar during difficult times.

Of course, a deep global downturn would affect most markets. However, the Federal Reserve expects only „a „mild recession” later this year, while the International Monetary Fund expects global growth to slow from 3.4% in 2022 to 2.8% this year.

If the economic clouds darken without causing a hurricane, it won’t be long before the dollar starts to shine again.