Interest rate differentials and policy rate expectations, in addition to robust growth in the U.S. compared to the G-7, provide a good reason to remain bullish on the U.S. dollar.
FX traders are going long
After a year marked by uncertainty and pessimism, net long positions of foreign exchange traders have reached their highest level in 10 years.
We attribute that confidence to U.S. monetary policy that will maintain the interest-rate pickup and demand for dollar-denominated securities, and also to the transaction demand for dollar-denominated commodities, with the scarcity of petroleum products priced in dollars unlikely to be quickly resolved.
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First, a change in U.S. monetary policy
The dollar is on an upswing, gaining 3% since Sept. 9. That nearly matches the gains made for the entire year of up and down trading.
The most recent dollar strength began in late summer in anticipation of a Federal Reserve rate hike on Sept. 16. Currently, the forward markets are pricing in Fed rate hikes in December and again early next year.
Expectations of a more aggressive U.S. monetary policy comes as central banks in the UK and Europe are likely be on hold. Those central banks are looking at sluggish growth that is less likely to support higher short-term interest rates.
That makes higher-yielding U.S. securities more attractive for global investors, lending important support to the dollar.
Second, an ongoing energy shock
The dollar’s strength is also because of increased transaction demand for the dollar as the distortions and increased cost of shipping crude and the shortages of distillates and other petroleum products pressure energy prices higher.
No matter the source of the supply, petroleum products are priced in dollars and sold within a global marketplace. Quite simply, local currencies need to be sold in order to buy energy priced in dollars.
We expect the energy market to remain unsettled, with no realistic idea when that might be resolved. The more it costs to buy energy, the stronger the demand for dollars.
Expectations for the euro
The European Central Bank is dealing with rising inflation and sluggish GDP, which is expected to grow by 1.0% this year and 1.3% next year.
In addition, it is probable that the ECB will bring the current rate hike cycle to an end in December while the inflation dynamics within the United States may demand a rate hike in March and quite possibly beyond should pricing pressures not abate soon.
At the same time, the U.S economy is operating at full employment and GDP is expected to grow at a full percentage point higher than the EU at 2.3% per year.
While the Fed can continue to raise its overnight policy rate to fight inflation, the ECB will be responding to stagflation by maintaining or lowering its policy rate, with the interest-rate differential supporting the dollar.
At present, FX traders are anticipating a decline in the euro.
Expectations for the Japanese yen
U.S. overnight rates hold a 270 basis-point spread over Japan’s overnight rate. That should be enough incentive for global investors to maintain upward pressure on the demand for dollar-denominated financial securities.
Still, there has been a significant change in Japan’s monetary policy as it abandons its zero interest-rate regime in favor of normalizing interest rates.
At the end of 2022, 10-year JGBs were yielding 0.25%. By October, the 10-year was trading over 3% before dipping 20 basis points to 2.8% in sync with bond markets among the developed economies.
It’s a good sign that Japanese investors can get a 3% return without having to hedge their exposure to the dollar, while Japan’s dependence on oil imports works in the dollar’s favor.
The commitment of traders reports an increase in net long-yen positions, moderating the demand for dollars that echoes the yen’s recent improvement in recent weeks.
The takeaway
The dollar is likely to benefit from what looks to be just the start of monetary-policy tightening and the high cost of dollar-denominated petroleum products.
As long as crude remains elevated, the increase in the transaction demand for dollar-based petroleum products is likely to put a floor under the dollar’s value.
And as long as the Fed is tightening monetary policy, the interest rate differential of dollar-denominated securities over foreign securities is expected to maintain upward pressure on the dollar’s value.
