The dollar could bring nasty surprises to investors

your currency, your problem. This is how US Treasury Secretary John Connolly explained the dollar to European leaders in 1971. This phrasing was appropriate. His boss, Richard Nixon, suspended the convertibility of the dollar to gold and demanded changes to the exchange rate system established in Bretton Woods in 1944. Other countries have been told to strengthen their currencies. Otherwise, America will impose trade restrictions. Compliance followed quickly. By the end of the year, the Smithsonian Agreement had devalued the dollar by about a tenth against major foreign currencies.

Today’s exchange rates are mostly floating and set by the market rather than tense negotiations. But the weaker dollar is once again breathing a sigh of relief. last September, dxyThe , a measure of the dollar’s strength against other currencies, hit a 20-year high (see chart). The yen plummeted. At one point, the pound appeared to be racing towards parity with the dollar. The euro has spent some brief periods under it. The US dollar has weakened since then. dxy10% below the recent peak.

Huge dollars create endless problems. Poorer countries tend to borrow in currency. As it intensifies, these liabilities become heavier. A strong dollar puts pressure on corporate borrowers, even in rich countries where governments issue debt primarily in their own currencies. According to his 2020 analysis by his three economists Matteo Maggiori, Brent Neiman and Jesse Schrager, in Australia, Canada and New Zealand, more than 90% of foreign-held corporate bonds are foreign currency, It was indicated that it is usually denominated in dollars.

Debtors are not the only ones to suffer. Product prices are displayed in dollars. The stronger the currency, the higher it will be. U.S. exporters are less competitive as products for foreigners become more expensive. American investors with foreign assets have their returns eaten away. There are good reasons, then, to support the retreat of the Greenbacks.

Unfortunately, relief may be temporary. To understand why, consider what caused the recent strength of the dollar. One is monetary policy. Throughout 2022, the US Federal Reserve has raised interest rates faster and higher than other central banks. This made the dollar a good target for the ‘carry trade’. Sell ​​low-yield currencies, buy high-yield currencies, and pocket the difference. The second cause is fear. Russia’s aggression in Ukraine, China’s unsustainable “coronavirus-free” policy, and the global economy’s move toward recession have all spiked market anxiety levels. In times of uncertainty, investors tend to reach for American assets that are perceived as safe. The final source is the US economy. It appears to be in a better position than many other countries in the world, due in part to rising energy prices and the country’s status as an energy exporter.

Indeed, the pace of Fed tightening has slowed and the Fed’s governor expects rates to peak this year. But they expect that peak to be higher than investors, at more than 5%, and to sustain longer before being cut. So does fear trading, which relies on unpredictable war progression.

Even a US recession may not bring the dollar down. The US dollar tends to do well both when the US economy is moving forward and when it is in recession. This phenomenon is called by currency traders the “dollar smile”. If US economic growth slows, the global economy is likely to be at risk as well, increasing the appeal of dollar assets as a safe haven.

But the best argument for the dollar going up is investor confidence that the dollar won’t go up. A recent survey of fund managers by Bank of America found that a near-record percentage believed the US dollar would weaken. The median forecast of forecasters surveyed by data provider Bloomberg is that the dollar will fall against all other major currencies this year and will continue to fall thereafter.

With $6.6 trillion traded against other currencies every day, it’s hard to imagine that at least some of these bets haven’t been made yet. Become. Shortly after the Smithsonian Agreement was signed, speculators caused the dollar to devalue further, throwing currency markets back into chaos and ultimately bringing the Bretton Woods system to its knees. Currently, the greatest pain occurs when the dollar is moved in the opposite direction. Investors may be shocked.

Read more from financial markets columnist Buttonwood:
Will 2023 be another terrible year for investors? (January 5th)
Indian stock market is soaring.They also have serious shortcomings (December 20th)
Every country is now an emerging market for fixed income investors (December 8)

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