Buttonwood

Bucking the trend

The dollar’s long rally seems to have halted
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AT THE beginning of the year the dollar was on a tear. In trade-weighted terms, it had risen by almost 20% since the start of July 2014. With the Federal Reserve tightening interest rates for the first time since 2006, the greenback seemed destined to head higher.

In fact, doubts were already emerging. In mid-December fund managers polled by Bank of America Merrill Lynch thought that being bullish about the dollar was the most overcrowded trade in the financial markets and that the currency was overvalued.

The dollar continued to rise for the first three weeks of the year but then the tide turned: since January 20th, the currency has fallen by 3.8% in trade-weighted terms (see chart). The main reason may be a perceived shift in Fed policy; as the year began, investors were expecting three or four rate increases in 2016. The latest statement from the central bank suggests that only two rises are on the menu.

The dollar’s ascent may have played a part in the Fed’s stance, since a stronger currency, by itself, represents a tightening of monetary conditions. The central bank has lowered its forecast for growth this year to 2.2%. Even that could be an overestimate: the Atlanta Federal Reserve’s GDPNow model, which tracks American growth, points to an annualised increase in output in the first quarter of just 0.6%. In a speech that took a cautious approach to further tightening, Janet Yellen, the Fed’s chairman, said this week that worries about global growth were another factor; similar concerns stopped the Fed from pushing up rates last September.

Ms Yellen’s remarks drove the dollar down and pushed share prices higher.

An exchange rate is the relative price of two currencies, so the dollar’s recent decline reflects more than just Fed policy. First, a pickup in commodity prices has allowed emerging-market currencies to rebound. Capital Economics, a research group, says its emerging-market exchange-rate index is at its highest since November. In some cases, currencies have been helped by tighter monetary policy: central banks in Colombia, Mexico and Peru have all pushed up rates. Another sign of confidence is a decline in the spread (the interest premium relative to Treasury bonds) paid by emerging-market debtors.

Second, recent market reaction to the policy moves of other central banks has been rather counter-intuitive. Normally, you would expect monetary easing by a central bank to lead to a weaker currency. But recent policy shifts by the European Central Bank and the Bank of Japan have sent the euro and the yen higher, not lower. It is not clear why. Some think these market moves indicate that central-bank policy is less effective than it was in the aftermath of the 2008 crisis. Others believe that negative interest rates hurt bank profits, and are thus a poor policy instrument.

This is a tricky area. Negative rates may well be designed to weaken the exchange rate or, at the very least, to stop a currency from strengthening. Other rich countries seem willing to turn a blind eye to a modest bit of depreciation. But if their own currencies appreciate too far, they will respond with monetary easing of their own. This fuels talk of “currency wars”.

But if central-bank easing doesn’t even have the desired impact on the exchange rate, what next? One answer could be outright intervention: selling the domestic currency and buying foreign assets. The Swiss National Bank pursued such a policy from September 2011, capping the franc’s level against the euro, before suddenly abandoning it in January last year.

Japan’s economy continues to struggle, more than three years after the launch of Abenomics; the latest figures show that industrial production fell by 6.2% in February. That suggests the Bank of Japan will be concerned about the yen’s strength. Mansoor Mohi-Uddin, a currency strategist at Royal Bank of Scotland, says that an appreciation of the yen beyond 110 to the dollar “will substantially increase the risk of the authorities intervening to counter the rise of the currency.”

A change in the dollar trend may simply have shifted the problem. A rising greenback was bad news for emerging markets: in those with pegs to the dollar, the appreciating currency weakened their competitive position in export markets; in those with floating currencies, debt-servicing costs jumped for companies that had borrowed in dollars. A weaker dollar makes life more difficult for advanced economies, which are counting on exports to revive their moribund economies (see Free exchange). They may spend the rest of 2016 figuring out what to do about it.

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