The dollar rules

July 13, 2022 10:13
Photo: Reuters

The first half of 2022 has been traumatic. Equity markets have suffered one of their worst six-month periods ever. Government bonds are undergoing a rare, significant decline. And the world of cryptocurrencies has experienced the rude awakening that many had long predicted for it.

Yet soaring above all the financial-market turmoil is the US dollar, which is now the strongest it has been in 20 years, having appreciated against many other currencies, including the euro. From a standard currency-valuation perspective, the dollar has reached the point at which many investors might seriously consider selling it. It is probably around 20% overvalued against most major currencies such as the euro and yen, and that simply does not happen very often.

But I would hasten to add that currencies usually don’t reverse course for valuation reasons. Rather, it normally takes action by policymakers to trigger a decline.

Consider the 1985 Plaza Accord, whereby France, West Germany, Japan, the United Kingdom, and the United States agreed to intervene in currency markets to weaken the dollar against the franc, Deutsche Mark, yen, and pound. Or consider US Secretary of the Treasury Robert Rubin’s public reversal from a strong-dollar policy in 1998, and US authorities’ decision to tolerate a sharp depreciation of the dollar against the euro in the early 2000s. In all of these cases, policymakers stepped in to engineer or assist a dollar decline.

The dollar’s current strength might seem remarkable, considering the fractiousness of US politics and some of the structural issues facing the US economy. From endlessly recurring balance-of-payment and current-account deficits and an aggressive stance against major foreign-exchange-reserve holders to culture wars over guns and abortion, there is more than enough to keep US society at a boiling point.

But now that the US Federal Reserve is tightening monetary policy to try to bring inflation back under control, investors once again appear to be favoring the dollar as their safe haven. In theory, higher inflation in a country is supposed to erode its currency’s purchasing power. But under today’s conditions (as in so many other periods I experienced during my days as a currency analyst), markets have a choice of betting on the Fed getting inflation under control or investing elsewhere in an uncertain world. For most, the choice is obvious.

Moreover, despite the dollar’s current overvaluation, it could strengthen even further unless some new headwinds appear. What could these be? First, and most obviously, the Fed could decide that it got things wrong and suddenly start easing its policy stance again. Such a move might seem unlikely; yet it is worth noting that the US bond market is undergoing a dramatic reversal, and the US money market is now starting to price in Fed interest-rate cuts (from levels higher than they are today) beyond this year. As a very successful macro-fund manager once said to me, if there is one thing that you can be sure about with the Fed, it is that it will change its views at some point.

A second possibility is that other major central banks start to outpace the Fed with their own policy tightening, as has happened during previous periods of dollar decline. But, given the state of most other economies, this scenario seems unlikely.

That leaves two other possibilities. One reason why the dollar’s rule lives on despite what is happening in the US and the world is that there are no significant strategic alternatives to it. The euro, for example, suffers from persistently recurring issues stemming from the makeup of its member states, not to mention the absence of a single euro bond that encompasses the entire union.

Some commentators would argue that the Chinese renminbi represents a plausible alternative. But until China encourages more widespread use of its currency and allows that usage to be liquid and free, the renminbi cannot pose a major threat to the dollar’s hegemony. True, at their annual conference this year, the BRICS (Brazil, Russia, India, China, and South Africa) discussed how they might promote wider use of their currencies. But we have heard this talk before, and there is little reason to think that such lofty ambitions will be realized anytime soon.

Historically, the dollar’s strength has usually started to reverse when the sitting US Secretary of the Treasury declares that the currency is too strong and raises the possibility of a US intervention in the market to weaken it. I have no doubt that this could happen once again under Janet Yellen – though, until there is more evidence of declining inflation expectations, it might be a bit early for such a move.

In any case, I suspect that those who do decide to sell their dollar holdings today will be happy with that decision in a couple of years. But I would advise them not to follow the currency’s minute-by-minute trading performance in the days after they make their move. Down that road lies only angst and second-guessing.

Copyright: Project Syndicate
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Jim O’Neill, a former chairman of Goldman Sachs Asset Management and a former UK Treasury Minister, is Chair of Chatham House.