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Will the US dollar’s strength finally be tested?

By the OFX team | 12 June 2024 | 4 minute read

After gaining 3% this year against a slew of currencies, the US dollar is finally taking a pause. Weak economic data has raised the prospect of an interest rate cut earlier than expected.

Two recent surveys suggest the heat is coming out of the roaring US economy. Manufacturers have turned more bearish, with the Purchasing Managers Index moving into a contraction phase for the second consecutive month after an expansionary reading in March.

Construction activity fell in April and also fell unexpectedly in May. Non-residential construction was the source of the weakness1.

US jobs data also pointed to a slowing economy.

Available jobs fell to the lowest level in 3 years, according to a survey by the Bureau of Labor. Although there was still a robust 8.06 million jobs on offer, this was a drop from last month’s 8.36 million – a surprise to the market. Healthcare, manufacturing and government jobs were all down, and accommodation and food services jobs were at the lowest point since the start of the pandemic2.

Retailers are beginning to recognise that consumers are feeling the financial strain. The New York Times reported major retailers like Target and Walgreens are implementing price cuts on thousands of products. Furthermore, market reports indicate companies acknowledge that shoppers are becoming more cost-conscious, leading them to conclude that price increases are no longer a viable strategy for maximising profits3.

US dollar drops as ‘economic exceptionalism’ evaporates

The weaker-than-expected data prompted a sell-off of the US dollar relative to its peers. The dollar index fell to its lowest level since mid-May, while the currency reached 2- and 3-week lows against the Japanese Yen and the euro, respectively.

“Markets are now questioning how long the U.S. exceptionalism theme has to go,” Boris Kovacevic, global macro strategist at global payments company Convera in Vienna, Austria, told Reuters4.

Traders factor in interest rate cuts sooner than expected

The bond market has reacted to trader-forecast interest rate cuts. Traders are increasingly investing in US Treasuries, effectively reducing the yields they pay (since bond prices and yields have an inverse relationship). This surge in activity is largely a wager that an official rate cut will occur in November rather than December.

The market’s perspective is that with inflation still above the US Federal Reserve’s (Fed) 2% target at 3.3%, recent economic data suggests the economy is cooling. This could lead to decreased demand, diminished wage pressure and a rate cut.

“The next move that the Fed is going to make is ultimately going to be one that protects the strength of the labour market, rather than one that in which they need to be fighting inflation,” Kelsey Berro, fixed-income portfolio manager at JPMorgan Asset Management, told Bloomberg.

US interest rates could lead to downward pressure on the dollar – all things being equal

A key phrase favoured by the economics profession is ceteris paribus. The Latin phrase translates to “all other things being equal” and is the basis of theoretical argument.

All other things being equal, an interest rate cut in the US is likely to result in a decline in its currency. But the US dollar’s strength has been as much about the relative poor performance of other countries as its own success.

The eurozone is a perfect example. It grew just 0.3% in the first quarter of the year and while inflation is still problematic at 2.6%, it is well down on the 10% it hit in late 2022 as a result of the invasion of Ukraine5.

The European Central Bank has flagged it wants to cut rates as soon as possible, possibly even this month to get its flagging economy back into growth. If that happens, the gap between the euro and the US dollar will widen in the greenback’s favour as investors seek the higher yields available in the US.

Therefore, the US dollar may not maintain its downward trajectory against the euro for long. But what about other currencies?

Central banks are generally cautious about the currency effects of cutting interest rates, especially during periods of unwanted inflation. While a lower currency helps exports, it also means imports are more expensive. That pushes inflation up.

In cutting rates for the first time in four years this week, Canada’s central bank Governor, Tiff Macklen made the call that rebuilding domestic economic confidence is more important than the Canadian dollar diverging from the US dollar. Other central bankers might take that as a sign that they can be more confident cutting rates as well. “If central banks see their counterparts heading that way, it does make it easier for other central banks to start cutting too,” a Bank of Montreal economist told Bloomberg6.

Where does that leave currencies?

The US dollar’s dip may not last if more central bankers start cutting rates to get momentum going. But perhaps the market is anticipating what many consumers are already feeling – that the era of high rates is starting to bite and a slowdown is imminent.

The next few months may be quite volatile in currencies as this period of consistently high rates comes to an end.

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