The US dollar has been on an uptrend since early 2018. Measured against top global currencies, the trade weighted dollar index has appreciated nearly 10% since the beginning of 2018. However, the latest bout of dollar appreciation is just a continuation of a cyclical appreciation that began in 2014. This article examines the drivers of dollar strength with a particular focus on Fed policy and safe haven flows.
Broadly speaking, a tightening in Fed policy such as via interest rate hikes leads to a fall in dollar bond prices and generates market expectation of a drop in the supply of dollar assets. Given the dollar’s status as the world’s reserve currency, this increases investors’ marginal willingness to pay for the safety of dollar assets and causes the currency to appreciate. Stanford economist Arvind Krishnamurthy documents empirical support of this channel of influence in his paper presented at the 2019 Jackson Hole conference.
The dollar had already started to strengthen by 2014 as the Fed began tapering its bond purchases under the QE3 (i.e. the third round of quantitative easing) program. The termination of QE3 in October 2014 signaled to investors the end of the Fed’s monetary easing cycle that began during the 2008-09 financial crisis. The lowering of interest rates to zero and the initiation of QE had pulled the US economy out of recession by mid-2009. Steadily declining unemployment and improving economic growth in the subsequent years increased investor expectations of monetary tightening and an associated drop in supply of safe dollar assets.
2015-2016: Policy Divergence Drove Dollar Strength
The Fed began its rate hike cycle in December 2015, raising rates in increments of 25 basis points – nine times in a span of three years. This came at a time when other major central banks were still in easing mode. Within three months of the Fed hike, the Bank of Japan had cut its rates to negative 0.1% and the European Central Bank (ECB) had cut its deposit rate, already at negative 0.1%, further to negative 0.4%. The ECB had also just begun its QE program earlier in the year. This divergence in monetary policy set the stage for dollar strength over 2015 and 2016. By the end of 2016, the Fed hiked again leading to a sharp rally in the trade weighted dollar index.
2017: Political Rhetoric and Global Recovery Weakened the Dollar
The steady decline in unemployment and improving economic performance led the Fed to hike rates thrice in 2017. However, the dollar weakened throughout the year despite a hawkish Fed due to adverse political rhetoric, general policy uncertainty following Trump’s election and strengthening of other safe haven currencies. Initial dollar weakness in 2017 began with investors taking profit after the Trump victory. Dollar sentiment took a further hit from the Trump administration’s very public divergence from the “strong dollar” stance that had been in place since the Clinton years. Protectionist policies on the trade front such as the withdrawal from the Trans Pacific Partnership agreement and renegotiating NAFTA further added to investor uncertainty about US policy. External factors that weakened the dollar included improvements in the economic conditions in Eurozone and Japan that resulted in a relative strengthening of the Euro and Yen versus the greenback.
2018-2019: Safe Haven Flows Drive Dollar Appreciation
The latest bout of accelerated dollar strength that started in early 2018 can be attributed to safe haven flows to dollar assets. That this latest run of dollar appreciation is exactly as long as the US-China trade war is hardly a surprise. The steadily deteriorating global economic outlook has driven investors to the safety of dollar denominated assets and fueled the dollar rally. It didn’t help that the early phase of this “risk off” episode coincided with four rate hikes (during 2018) which is dollar positive in itself. To be fair, there were enough domestic factors nudging the Fed towards rate hikes in 2018 – higher economic growth (at 2.9%, the highest since 2005) that got a boost from tax cuts and the Fed’s preferred inflation gauge touching its target of 2% during mid 2018.
Dollar Strength Is Here To Stay
The trade weighted dollar index has appreciated more than 24% since the end of QE3. A major contributor to this appreciation is investors’ search for dollar denominated returns at a time when other developed markets have negative bond yields. Given that alternative reserve currencies like the Euro and the Yen have negative yielding debt, collectively to the tune of $17tn and counting, it skews capital flows in favor of the dollar. Further, the US accounts for 95% of global investment grade debt leaving few alternative avenues of safe investment.
In light of the worsening global environment, the Fed went in for a precautionary rate cut at its July 2019 meeting taking the policy rate back to the range of 2.25%-2.5%. It also announced in early 2019 that it would halt the QE unwind by October 2019. The easing of monetary conditions from these Fed actions reduces one factor driving dollar strength. But the safe haven flows towards the dollar continue to overwhelm the influence of Fed policy in the current scenario. In other words, dollar strength is here to stay.
Macrologue 