The dollar is declining, with no apparent support. That’s because the recessionary factors seem to be dominating. But a reporter’s question about what factors might support the dollar prompted me to think about other influences that might work in a direction opposite the forces alluded to in the conventional wisdom.
First, a recap of the current state of play regarding the dollar.
Figure 1: Trade weighted value of the US dollar against major currencies. Source: Federal Reserve Board via St. Louis Fed FRED II.
Figure 2: Trade weighted value of the US dollar against broad set of currencies. Source: Federal Reserve Board via St. Louis Fed FRED II.
These two graphs highlight the fact that the drop in the dollar’s value is broad based, and unlike the past, is not restricted to just a movement against the other major currencies. From Bloomberg:
Dollar Trades Near Record Low Versus Euro Before Housing Data
By Min Zeng
Sept. 25 (Bloomberg) — The dollar traded within a cent of its record low against the euro before U.S. reports forecast by economists to show falling home sales and consumer confidence.
New evidence of slowing growth may encourage the Federal Reserve to cut interest rates at least once more this year, reducing the attraction of U.S. assets. The dollar sank yesterday to the lowest since September 1992 against a basket of six of its major peers.
“A negative dollar is still the overriding sentiment in the market,” said Michael Malpede, a senior currency analyst in Chicago at Man Global Research.
The dollar traded at $1.4084 per euro at 6:51 a.m. in Tokyo after yesterday touching $1.4130, the weakest since the European currency’s debut in January 1999. The dollar will drop to $1.43 per euro by year end, according to Malpede. The U.S. currency traded at 114.89 yen after falling 0.5 percent yesterday. The euro traded at 161.82 yen after declining 0.5 percent.
The U.S. dollar has fallen against 13 out of the 16 most actively traded currencies this quarter, depreciating 4 percent against the euro and 7.2 percent versus the yen. For the year, the dollar is down 6.7 percent against the euro and 3.7 percent versus the yen.
The one-month risk reversal rate for the euro-dollar rose yesterday to 0.35 percent, the highest on a closing basis since April, suggesting traders are willing to buy euro-dollar calls more than puts. A call option gives the right, but not the obligation, to buy euros against the dollar.
These are the standard macro factors. However, as mentioned in this post, other factors are at play, including the changing attitudes of central banks with respect to holding dollar assets, reserve accumulation, and dollar pegging.
From IDEAGlobal‘s FXAlert of 21 September:
Whilst we are not at the recessionary door
just yet, it will take very little in the data to
suggest it may start getting priced in. The
danger and curve ball in all this is that
inflation may doggedly refuse to lie down
and this is a volatile cocktail for the US
economy and their stock market. Funding
and liquidity remain the problem globally but
we see the investment guns turning on the
US and if there is any evidence that the
reserve managers are looking elsewhere for
a home then the size of the move could
surprise. We are at a very crucial stage of
the year and the investment cycles and the
central banks cannot afford to make any
mistakes from here.
What this quote highlights is that while there are (at least) two categories of forces pushing down the dollar’s value, there’s one that might possibly push the opposite direction — namely, inflationary pressures and the consequent policy response. While this seems an unlikely fear, I found this Reuters article of today of interest:
NEW YORK, Sept 24 (Reuters) – The Treasury Inflation Protected Securities (TIPS) market is likely to show inflation expectations rising through year end, a Pacific Investment Management Co fund manager said.
Break-even spreads between the nominal 10-year Treasury note yield and the equivalent TIPS should widen to near 250 basis points by December from about 230 basis points currently, John Brynjolfsson, a managing director at PIMCO, told a Euromoney conference on inflation-linked products in New York.
Widening break-even spreads reflect investors’ rising inflation expectations.
Higher inflation implies a weaker currency over time. But to the extent that the Fed responds to observed and anticipated inflation, then this implies higher policy rates in the future. Then the big question is which effect dominates in moving the dollar. In addition, higher interest rates have an impact on output and asset prices at different horizons. Hence, a surprise in inflation could prompt an increase in the policy interest rates (relative to what was anticipated), which when combined with sticky prices would lead to a higher real interest rate that appreciates the dollar instantaneously and in the short run (Note: This argument relies upon a Taylor rule interpretation of monetary policy — the currency value implications of which are drawn out in this post).
To the extent that higher interest rates depress economic activity in the medium term, this will tend to lead to a weaker currency at the longer horizon. This means that the path of the dollar may be subject to more influences than would be obvious at first glance. And that changes in policy rates may very well have different impacts at different horizons.
(By the way, I’m using a loose definition of “stagflation”; usually it applies to a period of declining output and rising inflation. Here, we’re considering declining output growth (with a possibility of declining output level) with recalcitrantly durable inflation, or slightly rising inflation.)
foreign exchange reserves,
Federal Reserve, and inflation.