After steadily marching to a secular peak against a basket of its key trading partners last fall, the US currency has been quickly declining. Moderating expectations for US interest rates explain much of this about-face, but not all. Indeed, to understand the most recent dollar weakness — and more importantly, where it is likely to be headed next — events outside the US will matter as much or more than what happens within its borders.
It all comes back to the dollar’s unique standing in global currency markets, which allows it to appreciate in two opposing environments. In part because of its global reserve currency status, it does well when the world is not doing well. In that scenario, investors want the relative liquidity and safety of US assets, especially Treasury bonds. This even tends to be the case when such shocks are home grown, as was the case after the US debt ceiling crisis in 2011.
At the same time, though, the dollar also strengthens when US economic growth is robust — and specifically more so than its peers. This often goes hand in hand with expectations for relatively more attractive US yields and equity returns that increase dollar demand. Where the currency tends to underperform is when the country is doing OK, but no better (or relatively worse) than peers. That environment often means US interest-rate differentials are less likely to be the dominant factor pulling capital towards America. In such circumstances, US investors often have greater confidence to take more risk on overseas assets, especially if prospects for those markets are improving. That is exactly what has happened so far in 2023 — the dollar has quickly lost ground against most of its developed and emerging-market counterparts.
Source: Financial Times
