The third quarter of 2024 might have been good for equities, but it was less so for the US dollar. The US dollar index (DXY) dropped around 4.8% against a basket of currencies, turning in its worst quarterly performance in nearly two years. According to Reuters, Commodity Futures Trading Commission data indicates that net bets on a weaker dollar have grown to $14.1 billion in futures markets, the highest level in about a year. Is this a sign of an incoming bear market for the dollar or will the US dollar surprise with resilience?
While many suggest that the recent decline was a result of de-dollarisation; a reaction to burgeoning US debt; or ahead of uncertainty regarding the US election outcome, we explain why we feel that the reaction is primarily to the level of US interest rates and specifically around the future expectation thereof.
The chart below shows that, over the past five years, the performance of the dollar has tended to correlate strongly with the expectation of future US interest rates. The white line is the interest rate curve’s expectation of the Fed rate one year forward. The DXY, in yellow, indexes the US dollar against a basket of its developed market peers, namely the euro, British pound, yen, Swedish krona, Swiss franc, and Canadian dollar.
We therefore contend that the direction of the dollar will largely depend on how the reality of the rate cutting cycle plays out over the coming months versus the degree to which it is already priced in.
Are future Fed cuts already priced into the dollar?
As depicted in the chart below, with the current average rate at 4.88% and the rate in a year’s time at 3.52%, markets would appear to already be pricing in a further 136bps of Fed interest rate cuts over the next year. Despite the Fed starting the interest rate cutting sequence with a blockbuster 50bps cut, this expectation is ahead of the Fed’s own forecasts and we believe this expectation is aggressive – especially with economic data pointing to irrepressible economic growth and labour market strength in the US. The market might, therefore, be disappointed by the level of interest rate cuts over the coming year, and the dollar may reverse some of its recent weakness.
The strength of the US economy relative to its major trading partners also offers us reason to doubt that we are at the cusp of a period of prolonged dollar weakness. Not only will it most likely prevent the Fed from accelerating its own rate cutting cycle, but other central banks are also likely to accelerate interest rate cuts to bolster their own growth, as inflation becomes much less of a conundrum.
Therefore, the possibility of US interest rates remaining higher for longer – just like inflation stayed higher for longer – is reasonably good. As a result, the differential between US interest rates and those in developed country peers in the DXY will most likely remain more consistent with today’s levels. Investors won’t have any incentive to abandon US cash or treasuries in pursuit of higher yields in other developed markets.
Another factor that may support the US dollar is ongoing geopolitical instability. There is a real danger of conflict in the Middle East turning into a full-blown confrontation between Iran and its proxies versus Israel, the US, and their allies. Fear of a war that destabilises the Middle East and disrupts oil supplies and other supply chains would send investors to safe haven assets, which would strengthen the dollar.
The US presidential race is also close, and Donald Trump’s odds of returning to the White House are currently even. If he wins, there’s a possibility he could impose high tariffs on imports and use the US dollar as a political tool. In the short term, this could strengthen the dollar. However, as we have shown, the long-term outlook depends mostly on interest rate movements and the strength of the US economy.
Risk-on could benefit some currencies
For all the reasons outlined above, our base scenario is that the US dollar will not weaken dramatically over the next few months. We have seen emerging market currencies, including the rand, already benefit from a weaker dollar in anticipation of future interest rate cuts in the US. We therefore suggest that further US interest rate cuts are already priced in.
But, as interest rates continue to glide down in the US and its developed market peers, emerging markets might benefit from a risk-on environment and a further search for yield. This depends on the Fed managing a delicate dance of taming inflation and supporting growth across the rate cutting cycle.
Emerging market currencies are sensitive to global uncertainty, however, especially when unexpected events cause investors to seek safer assets. For investors with internationally diversified equity portfolios, even if denominated in US dollar, their global purchasing power should stay stable, regardless of how the dollar performs.
