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March 6, 2023

Bear Market Rally or New Bull Run? How the Dollar’s Bounce Back is Affecting the FX Market

The dollar recovered from recent lows during the last four weeks.

The dollar's (DXY) movement versus other currencies has been a hot topic over the past year. 2022 saw the greenback move increasingly higher, testing multi-decade highs before pulling back in the 4th quarter. The result was a net gain of just over 8% for the year. The dollar continued to move lower during January but then reversed course and rallied during February. The rally has taken the dollar back into positive territory for the year. The question for the FX market is: Is the rally a technical correction in an ongoing downward trend, or will the dollar continue to strengthen?

USD Bear Market Rally or New Bull Run?

Why the dollar rose

Much of the year-end drop in the dollar was driven by data indicating that inflation was dissipating. At the Fed's (FOMC) most recent policy meeting, rates were raised by 25 basis points, less aggressive than previous increases. U.S. Federal Reserve Chair Jerome Powell used the term "disinflation" 15 times in his post-meeting press conference, leading markets to believe that the Fed was getting close to the end of the tightening cycle. Subsequent economic data has been surprisingly strong. Two days after the Fed meeting, the US jobs report showed an unexpectedly robust round of hiring in January, adding 517,000 new jobs when the market was looking for less than 200,000. However, later reports (CPI and PPI) showed inflation running hotter than anticipated. On the last Friday of February, the Fed's preferred measure of inflation, the Personal Consumption Expenditures Index (PCE), confirmed that inflation was still above expectations. As a result, market-driven increases in US interest rates have effectively pushed the dollar higher.

The case for a stronger dollar

The 2022 run-up in the dollar was primarily driven by the Fed's rapid increase in interest rates. It was the sharpest increase in rates since the early 1980s. By the end of the year, markets expected that the Fed was near the end of the cycle of increases. Data showing that inflation is still "sticky" and that the Fed may raise higher rates than anticipated contradicts this assumption. Once again, interest rates appear to favor the greenback.

Currently, the dollar remains the reserve currency of the world. Many economists have been predicting an end to the "King Dollar," expecting other currencies to supplant the dollar's role in international transactions. Even though Saudi Arabia has recently stated it is "open" to the idea of trading in currencies besides the US dollar, they continue to favor the dollar because of its free convertibility and liquidity. Oil producers are also acutely aware of China's history of controlling commodity prices, so they are reluctant to give China power over oil pricing.

Another factor favoring the dollar is the relative strength of the US economy. The economy remains resilient even though interest rates have risen substantially over the past year. Jobs continue to be added, and consumers continue to spend. US corporations are still showing evidence of strong profits. The same cannot be said for many other countries, particularly emerging markets. If the US economy continues outperforming its counterparts, it could continue attracting overseas investment, increasing the demand for dollars.

The dollar also benefits from its status as a "safe haven." Investors are rightfully concerned about Ukraine's ongoing war and proximity to Europe. There are also fears about China's growing militarism toward Taiwan, but the US is perceived to be less affected by these issues than other countries. Therefore, investors will likely continue to buy dollars for safety.

Factors Driving Dollar Strength:

  • The Fed is likely to continue raising interest rates.
  • Dollar's role as global reserve currency.
  • Weakness in other countries' economies.
  • "Safe haven" buying in a tumultuous world.

Why the dollar could weaken:

The battle against inflation has become global as other countries match the US with interest rate increases. As interest rate differentials narrow, the dollar becomes less attractive, and demand for dollars decreases.

Despite the pullback from the September 2022 high, the US dollar remains overvalued against many other currencies. One measure of purchasing power parity, the Economist's Big Mac Index, shows the Japanese yen is still 40% undervalued versus the dollar.

As mentioned above, the dollar still benefits from its status as the world's reserve currency. This places a burden on emerging economies with dollar-denominated debt. Many countries may try to replace the dollar for future borrowing needs, which could reduce the demand for US currency. And several countries have expressed interest in exploring the potential of using digital currencies, again potentially reducing demand for dollars. The days of "exorbitant privilege" (a term coined in the 1960s to describe the dollar's special status) may end.

Another factor that could derail a dollar rally is the US national debt. It has grown exponentially over the past few years. The debt has increased, and with higher interest rates, the cost to service the debt will increase dramatically. Projections show that in 2024 the US will spend more on debt service than the military. Additionally, a debt default because of political infighting over the debt ceiling could cause a loss of confidence in the dollar and trigger a significant price drop.

Factors Leading to a Potential Weakening of the Dollar:

  • Interest rate differentials narrow as other countries raise interest rates.
  • The dollar is overvalued by measures of purchasing power parity.
  • The dollar's role as the reserve currency is lessened.
  • An increase in concerns about the cost of servicing the United State's national debt.

Takeaways:  There is no way to precisely predict what will happen to the price of the dollar. There is a case for movement in either direction. For companies with FX exposure, the key to surviving this uncertainty is preparation. That means analyzing potential outcomes from either a strong or weak dollar and then developing a strategy to mitigate that FX risk. 

In the past, only giant corporations could afford to hedge their foreign exchange risk and leverage the volatility of FX to their favor. But Pangea Prime provides a customized hedging solution for enterprises and nonprofits of any size. A few clicks and keystrokes on the Prime platform replaces the work of what used to take an entire department of FX professionals. 

Where the dollar will go is ultimately unpredictable, but Pangea makes the complexity of hedging simple and predictable.

Get in touch with us to learn how your business can save time and resources through hedging.

Pangea

AI Hedging for the Future. Empowering organizations to intelligently manage their Foreign Currency Exchange Risk with AI and Automation at scale in the cloud.

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