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Key Takeaways
- The dollar’s rally in 2021 was a big surprise.
- Themes that support the dollar should continue for at least the rest of 2021.
- The US labor market may determine the future of Fed policy and the dollar.
The DXY index contains six component currencies: EUR, JPY, GBP, CAD, SEK, and CHF.
Summary:
This year’s rally in the dollar was a big surprise.
The decline in the dollar in 2020 was expected to continue in 2021 and beyond. In fact, many technically-focused currency forecasters (including me) believed the dollar would continue to weaken for another five years to complete a 15-year cycle that began in 2011. Instead, the greenback pushed higher against nearly every foreign currency. Only three petro-currencies – the Russian ruble, Canadian dollar and Norwegian krone – and a few others managed gains against the dollar.
Themes that support the dollar should continue in Q4.
The dollar should remain firm in Q4, as we expect several supports to continue. First, US interest rates are relatively high. Second, the Federal Reserve appears ready to cut stimulus more aggressively than most of its central bank peers. Third, the dollar continues to fulfill its role as a safe-haven asset in an increasingly uncertain world filled with economic slowdowns, supply bottlenecks, labor shortages, an energy crisis, rising inflation, a persistent Delta variant, US political feuding, and China’s regulatory crackdowns and looming property debt crisis. One potential snafu – a collapse in US equities could cause the Fed to deviate from its tapering plans, pushing US Treasury yields and the dollar lower.
The US labor market may determine the future of Fed policy and the dollar.
As high inflation continues to be priced into the markets and has the Fed ready to taper its bond buying program, a healthy US labor market may take priority and lead to the reappointment of Fed Chair Powell.
Several factors are influencing the value of the dollar:
Central banks are shifting gears to face inflation.
Last month, Norway’s central bank became the first G-10 central bank to hike interest rates since the onset of the pandemic joining New Zealand’s central bank and several EM central banks already raising rates – Mexico, Brazil and Russia. Along with the Fed, the Bank of England has signaled that they may soon begin tapering their bond buying programs, as central banks in Canada, New Zealand and Australia already have. In contrast, the European Central Bank and Bank of Japan remain doves.1 Increasing signs of ‘stagflation’ will challenge central banks to support economic growth while keeping inflation under control.
“Risk-on” sentiment drives US equity markets higher despite dismal economic outlook.
The S&P 500 is approaching fresh all-time highs, while data from the Atlanta Fed shows the US economy growing at an annualized rate of only 0.5%.2 Bank of America’s Global Fund Manager Survey for September reveals a dramatic fall in optimism with respect to both US inflation and growth.3 Bloomberg columnist John Authers explains this contradiction between the rising stock market and the falling economy: “TINA” (There is No Alternative – to stocks) appears to have morphed into her fearsome sister “TINA RIF” (There is No Alternative – Resistance Is Futile).4 The S&P 500 outperformed nearly all foreign stock indices in H2, which led to increased demand for the USD.5
Central banks are shifting gears to face inflation.
Geopolitical risks are not yet impacting financial markets.
According to a recent BlackRock study, markets remain relatively unmoved in response to major global geopolitical risks, including: 1) global technology decoupling by the US in the wake of China’s continued regulatory crackdown; 2) ramped up regulation of Chinese companies listed in the US; 3) the resurgence of Covid-19; 4) cyberattacks on critical physical and digital infrastructures; and, 5) emerging market political crisis as Covid-19 drives divergence between developed and EM countries.6 These risks are all tailwinds for the safe-haven dollar.
FX speculators are positioned exceedingly “long” US dollars.
According to the most recent CFTC Commitments of Traders report, large currency speculators, as a group, have built up the largest net long US dollar positions since mid-2019.7 In other words, being long dollars has become a “crowded trade,” subject to a big sell-off should there be “rush to the exit.”
Technical:
The dollar index (DXY) is up nearly 6% for the year, and currently trades within an uptrend which began in January.8 In the near to medium-term, we predict it will move higher by another 2.0%-2.5%; only a drop in the index below September’s low would reverse that prediction. In 2022 (probably in Q2), we expect the start of a global economic recovery, which should turn the dollar lower, and finally back into its long-term decline.
For more analysis on FX markets or information regarding SVB's FX services, contact your SVB FX Advisor or the SVB FX Advisory Team at fxadvisors@svb.com.
