investment viewpoints

What will pull the dollar back?

What will pull the dollar back?
Florian Ielpo, PhD - Head of Macro, Multi Asset

Florian Ielpo, PhD

Head of Macro, Multi Asset

The dollar normally pulls back in these end-of-cycle phases, but not this time. The US currency has recently enjoyed eight consecutive weeks of gains. In this weekly installment of Simply put, we look at the curious trend of relative rates.

The anticipated ‘soft landing’ is clouding the situation, and the recent marginal improvement in the US economy is casting doubt on inflation’s ongoing downtrend. With interest-rate differentials in focus, watch out for surprises as the macro environment remains volatile and the market struggles to keep up. So, does this cycle end with the dollar up or down?


Need to know:

  • A fall in the value of the dollar is synonymous with the end of the cycle
  • The Federal Reserve is pursuing a more aggressive monetary policy than other central banks, and this has pushed US real rates higher. This is what’s holding up the dollar
  • The foreign exchange market has its eyes firmly fixed on these rates – as soon as the rest of the G10 adopt a more aggressive stance, the dollar's upwards trajectory should subside


Why should the dollar come down?

Why does the dollar fall at the end of the cycle? As the US cycle tends to run ahead of the rest (notably Europe’s), the Fed tends to reach its terminal rate first. Then, it's up to the other G10 central banks to gradually continue raising rates for one or two more quarters, before inflation is settled for good. This is usually when recession sets in. 

During this last adjustment, further rate hikes by the G10 banks typically erode the value of the dollar against their respective currencies. Of course, this is rarely a linear development, and the current cycle is no exception. Nevertheless, the US cycle remains well ahead of Europe's, as can be seen on our nowcasting indicators chart.

Real 10-year rates are probably one of the best measures of the restrictive nature of monetary policy. Their relative movements are thus very naturally linked to the question at hand. When the gap between US and G10 real rates narrows, the dollar must lose value. While this usually tends to happen at the end of the cycle, it is not the case today. 

Since the beginning of August, US rates have soared, leaving their European counterparts in the dust. This is due to several economic factors, such as the fact the US economy seems to be doing better than expected and has recently entered a recovery phase – even though it has not yet experienced a recession. The national deficit is probably one of the main reasons for this state of affairs. The deficit reached 8% of GDP in 2023, supporting growth that the Fed is trying to slow down. 

Figure 1: Eurozone real rates vs real rates in the US


Source: Bloomberg, LOIM as at September 2023.


Where are markets focused on?

At this stage of the cycle, the curious trend in relative rates may come as a surprise. However, investors should continue to monitor them, as these rate differentials account for a considerable proportion of the dollar's movements in effective exchange rates. This can be seen in figure 2, which plots the relative influence (rebased to 100%) of the major macro factors driving exchange rates: 

  • Real-rate differentials
  • Growth differentials as measured by relative surprise indices
  • Relative equity-market attractiveness, as measured by the relative performance of regional indices such as the S&P500 in the case of the US 

As the chart clearly shows, the market's attention is where it should be right now: not on equities, as was the case at the end of 2022, nor on relative growth differentials, but on rates spreads. 

The US cycle seems vigorous at the moment, and the market is welcoming this strength by letting real rates rise faster than elsewhere, supporting the dollar. However, if there's one economic zone with a non-energy inflation problem, it's continental Europe, not the US. The moment markets realise the importance of this discrepancy, the dollar could start to climb down. And without the dollar's decline, emerging markets won't outperform. 

So, let's enjoy the last fruits before the winter, and reap the rewards in due course. 

Figure 2: Relative importance of major macro factors in euro-dollar parity

Source: LOIM, Bloomberg as at September 2023. 


Simply put, the dollar's current ascendence is rooted in the fact that US real interest rates are rising faster than elsewhere in the G10 economies.  Should other central banks adopt a more aggressive policy stance, this strength will fade.


Nowcasting corner

The most recent evolution of our proprietary nowcasting indicators for global growth, global inflation surprises, and global monetary policy surprises designed to track the recent progression of macroeconomic factors driving the markets.

Our nowcasting indicators currently show:

  • The growth situation has remained steady: the US continues to recover while the Eurozone and China remain in a downtrend
  • Inflationary pressures remain the same as for the past four months: low but rising
  • Monetary policy should be driven by a form of moderation, without surprise moves by  central banks 


World growth nowcaster: long-term (left) and recent evolution (right)

World inflation nowcaster: long-term (left) and recent evolution (right)

World monetary policy nowcaster: long-term (left) and recent evolution (right)

LOIM’s nowcasting indicator gather economic indicators in a point-in-time manner in order to measure the likelihood of a given macro risk – growth, inflation surprises and monetary policy surprises. The Nowcaster varies between 0% (low growth, low inflation surprises and dovish monetary policy) and 100% (the high growth, high inflation surprises and hawkish monetary policy).

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