Condivergence: Where is the US dollar heading?

This article first appeared in Forum, The Edge Malaysia Weekly, on January 16, 2023 - January 22, 2023.
There are tentative signs that inflation may have peaked in the near term, particularly with global freight rates normalising. That being the case would ease US dollar strength, but this trajectory is far from certain.

There are tentative signs that inflation may have peaked in the near term, particularly with global freight rates normalising. That being the case would ease US dollar strength, but this trajectory is far from certain.

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Last July, as the US Federal Reserve started raising interest rates, the yields on US Treasury bonds inverted, with spreads between long-dated and short-dated papers turning negative. An inverted yield curve, generally considered a harbinger of recessions, last occurred near the bursting of the dotcom bubble in 2001 and the 2008 global financial crisis. In ensuing periods of uncertainty, the US dollar tends to rally in a “flight to safety”, as in September 2022, when the greenback reached a 10-year peak.

Since then, the US dollar has retreated as the market speculates that the Fed may be nearing the peak of interest rate hikes, while the European Central Bank (ECB) and Bank of England have also raised rates. The Bank of Japan is the only major central bank to hold off on bank rate adjustments. Will the greenback strengthen or weaken in 2023?

The December 2022 Federal Open Market Committee meeting minutes show that the Fed believes recession to be “plausible” this year. Because investors are buying more long-dated papers, the Treasury yield inversion has become more pronounced, even as the US central bank continues to shrink its balance sheet. Overall, analysts have become more bearish on the prospects of a worldwide recession as Europe continues to be dragged down by the unresolved war in Ukraine, while China has embarked on an untravelled path of abandoning its zero-Covid policy stance. The general mood of uncertainty provides ingredients for continued US dollar strength.

Inflation, however, is the real spectre, which came roaring back from the volatile mixture of untamed stimulus unleashed by governments during the 2020/21 Covid-19 pandemic, on top of supply chain disruptions from war and sanctions. The Fed raised interest rates seven times last year, taking the benchmark rate from zero to the 4.25% to 4.50% range. Nevertheless, overall inflation has remained high and above Fed estimates, with the US Consumer Price Index and core CPI inflation registering a 7.1% and 6% year-on-year increase respectively in November. In addition, the labour market remained tight and wage growth was buoyant. Given the underlying trend of supply chain decoupling and the business sector needing to fund climate change action, the underlying cost inflation will make it more difficult for the Fed to reverse course on interest rate hikes. The market consensus believes that interest rates will peak around 5% to 5.5% sometime this year, which underwrites US dollar strength as investors are drawn to long-term Treasuries.

We cannot view the US dollar and the Fed’s interest rate stance in isolation. The ECB and Bank of England were initially slow to raise interest rates because of high levels of domestic sovereign debt. That slowness gave the US dollar an advantage, but there are limits to how much currency weakness the eurozone and Britain are prepared to accept. Even the Bank of Japan cancelled its zero-bound yield target on 10-year government bonds in December 2022, after the yen depreciated to levels not seen since 1998. So, the euro, pound sterling and yen have appreciated somewhat in the last two months.

There are tentative signs that inflation may have peaked in the near term, particularly with global freight rates normalising. That being the case would ease US dollar strength, but this trajectory is far from certain. The volatility in long-dated Treasury yields currently reflects market uncertainties because increased geopolitical tensions may affect oil and gas supplies as well as key commodity prices.

We are in this delicate situation of our own making. The McKinsey Global Institute estimated that the surge in asset prices in 2020/21, including in cryptocurrencies, was fuelled by debt and equity liabilities rising by US$50 trillion and US$75 trillion respectively. Countries chose stimulus to address the pandemic that led to new debt being created at a rate of “$3.40 for each $1 in net investment”. As the Fed and other central banks walked back on this balance sheet build-up last year, global equity prices fell by 30% in real terms and bond prices fell by 20%. This is an ongoing challenge and disorderliness could easily tip the world into recession. Again, uncertainty favours a stronger US dollar.

An important consideration in the outcome between global recession and recovery will be China, accounting for 18% of world gross domestic product and global net worth in 2021. The country surprised everyone by rapidly emerging from its Covid-19 isolationism this month. Three years of restrictive policies have hurt business and consumer sentiment, with the renminbi devalued to pre-pandemic levels of over seven yuan against the US dollar. China now aims to stimulate its economy and stabilise its housing market. This countercyclical agenda could add a fillip to global aggregate demand, thus pushing back up commodity prices. Consequently, whether the world will enter recession or recover with sustained inflation depends critically on China’s economic performance, which is very difficult to predict at this stage.

Winston Churchill once said, “It is always wise to look ahead, but difficult to look farther than you can see” — a wise reminder for anyone making predictions. This is not investment advice but on balance, we think US dollar strength should prevail for longer. The other central banks fear recession too much to be aggressive on interest rate hikes. When push comes to shove, American politicians still understand that their debt ceiling would have to be raised. Given so much uncertainty on many fronts, investors will still stick to the most liquid US dollar.


Tan Sri Andrew Sheng writes on global issues that affect investors. Tan Yi Kai is a Malaysian multi-asset trader based in Hong Kong.

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