- Trade-weighted DXY index puts US dollar near one-year high
- Dash for haven assets could be boosting the buck
- Slower-than-expected rate cuts from the Fed also a factor
- Strong dollar traditionally a negative for emerging markets and commodities
- Raw material prices seem unconcerned for now
“Investors and traders are nervously watching events in the Middle East for many reasons, and, from the narrow and selfish perspective of financial markets, they will be relieved to see the oil price keeping its cool in the wake of the weekend’s events,” says AJ Bell investment director Russ Mould. “However, demand for a haven means the US dollar is nearing a one-year high against its major international counterparts, according to the trade-weighted DXY basket, and attention must always be paid when the world’s reserve currency makes a major move up or down.
“The DXY basket, nicknamed ‘Dixie,’ is comprised of the pound, euro, yen, Swiss franc, Canadian dollar, and Swedish krona. The dollar’s gain towards a twelve-month high of 106 can be attributed to geopolitical concerns, although there may be other factors at work, too.
Source: LSEG Datastream data
“The US economy continues to perform more strongly than most of its Western counterparts and although this may be down to fiscal stimulus from the Biden administration, which continues to pile on the spending (and pile up debt), one result is that the US Federal Reserve is yet to cut interest rates. Markets began 2024 expecting six one-quarter-point rate cuts this year, starting in March, but have cut that back to two starting in September as growth has proved robust and inflation sticky.
“The Fed Funds rate of 5.5% must therefore be tempting for currency traders and investors, as they are getting a premium return on their cash in the globe’s reserve currency, relative to other major alternatives.
Source: LSEG Datastream data
“Although ‘Dixie’ stands well below this century’s prior highs of 113 (in 2022) and 121 (in 2001), let alone 1985’s all-time peak above 160, investors will be keeping a close eye on the greenback, because two asset classes are particularly sensitive to the dollar, at least if history is any guide.
“The first is emerging equity markets.
“They do not appear to welcome a strong dollar, judging by the inverse relationship which seems to exist between the DXY and MSCI Emerging Markets (EM) benchmarks. Dollar strength at the very least coincided with major swoons in EM (or periods of marked underperformance relative to developed markets) during 1995-2000 and 2012-15. Retreats in the greenback, by contrast, appeared to give impetus to emerging equity arenas in 2003-07, 2009-12 and 2017-18.
“This also makes sense in that many emerging (and frontier) nations borrow in dollars and weakness in their currency relative to the American one makes it more expensive to pay the coupons and eventually repay the original loans.
Source: LSEG Datastream data
“The second is commodities. Most major raw materials are priced in dollars. If the US currency rises then that makes them more expensive to buy for those nations whose currency is not the dollar or is not pegged to it and that can dampen demand, or so the theory goes. It can be argued that there is an inverse relationship between ‘Dixie’ and the CRB Commodities index.
Source: LSEG Datastream data
“However, the past is no guarantee for the future and chart-watchers will note how the CRB Commodities index is nearing a five-year high even as the dollar rises – strength in gold, copper, silver, oil and cocoa, to name but five, look to underpin the benchmark’s advance.
“Were the apparent long-term inverse relationship between the buck and commodities to break down, that could have huge implications for markets. A strong dollar is traditionally seen as disinflationary, even deflationary, as it makes both borrowing in the US currency and commodities more expensive, thus dampening demand.
“But if raw material prices keep going up when the dollar is strong, that could be inflationary or at least be enough to suggest the current run in the greenback is not going to last.
“America’s galloping national debt would become an even bigger burden if the Fed does not cut soon, thanks to the ever-growing interest bill. Rising raw material prices could be one way in which markets are suggesting the Fed may indeed start to reduce interest rates and take a risk with inflation, if the US keeps on racking up annual deficits than run at 5% to 7% of GDP, because the annualised interest bill is now $1 trillion a year.”
