Tensions mounting in foreign exchange markets as dollar surges

The dollar is moving sharply higher on foreign exchange markets. Changing monetary policy expectations and geopolitical tumult are ripping up expectations from earlier this year of the dollar easing amid a softening US economy and accommodation from the Federal Reserve.

The latest sticky US inflation data, coupled with continued robust activity and turmoil in the Middle East, has sparked surging dollar demand (Figure 1). The market has gone from pricing six Fed rate cuts this year to well under the three projected in the latest Fed dot plot.

If inflation is coming down in a bumpy manner and real activity is holding up, why should the Fed cut this summer? Using Stephen Jen’s dollar smile picture, it’s as if both sides of the smile – a risk-on economy and risk-off geopolitics – are underpinning the past week’s breakout.

Figure 1. Demand for the dollar is surging

Source: Board of Governors of the Federal Reserve System

Fears of fragmentation and protectionism may be further stirring the pot. President Joe Biden has largely kept the previous administration’s tariffs and many expect that a Biden victory in the election later this year would be followed by more trade restrictions on China. Presidential candidate Donald Trump is threatening a 10% across the board tariff and 60% on China.

Trump’s former US trade representative – Robert Lighthizer – is reportedly interested in ‘devaluing’ the dollar and often appears on lists for a Trump Treasury secretary. The idea is damaging in and of itself – it could harm trust in the dollar as a reserve currency, trigger global financial market volatility and boost inflation. Of course, when the Trump administration slapped tariffs on China amid a loose fiscal/tightening monetary policy stance, the dollar rose sharply, causing an angry President Trump to designate China for currency ‘manipulation’.

European Central Bank set to cut rates first?

While foreign exchange markets are being dominated by a dollar story, it takes two to tango. European growth data is anaemic and stagnant. Progress in bringing inflation down to target is occurring faster than generally anticipated.

The European Central Bank is on track to cut rates in June, and now well before the Fed. Some participants wonder if the ECB might hesitate to cut rates in view of this desynchronization and a weak euro. But the ECB leadership is rightly indicating otherwise as it is guided by its price stability mandate, is a bastion of free floating and doesn’t target exchange rates. Of course, were a weaker exchange rate to materially affect the price outlook, that would factor into the ECB’s calculations.

Japan and China also face difficult circumstances. The Japanese Ministry of Finance is uncomfortable with the yen’s sharp weakness against the dollar. The Bank of Japan finally lifted rates last month, but never so cautiously. While analysts expected that action would strengthen the yen, the move was swamped by the changed US monetary policy expectations. Japanese authorities well understand that the yen’s movements are being driven by the US monetary policy outlook and geopolitics and that their hands are largely tied.

But the yen’s weakness is a political liability. What to do? The BoJ isn’t interested in a rapid tightening, and it is also a strong proponent of free floating. Meanwhile, the MoF – responsible for foreign exchange but not monetary policy – ​​must deal with the fallout. As an institution, the MoF is far less a believer in targeting foreign exchange and an activist currency policy than in decades past. But something must be done, so it is reverting to its standard playbook of jawboning.

The MoF is also threatening to intervene – and it may. But it would most likely do so without much conviction, knowing that a large, sustained campaign wouldn’t be practical or effective and the yen won’t turn until US monetary policy expectations shift.

China’s situation is even more complex

With a whopping 10% of gross domestic product trade surplus in manufacturing, China is headed towards a significant current account surplus this year. But the economy faces massive headwinds, confidence is low and foreign firms are stepping back. The upshot is massive capital outflow, pressing the renminbi. The weak renminbi against the dollar constrains monetary policy accommodation and the authorities are wary of deploying large fiscal stimulus due to high leverage.

Additionally, Chinese stimulus usually supports infrastructure and investment, rather than consumers and better knitting of the social safety net, which would only aggravate enormous and justified concerns in the US and Europe about Chinese overcapacity.

The authorities are strongly resisting renminbi depreciation against the dollar if not de facto pegging the exchange rate – which must be a relief to US authorities who call for greater renminbi flexibility. (That means renminbi appreciation against China’s competitors, which is no big deal.) On the plus side, there is debate over China’s challenged growth model and overcapacity, not on the renminbi exchange rate as would have happened over a decade ago.

Emerging market currencies are also facing similar pressures.

Foreign exchange markets are being dominated by a dollar story. This story mainly reflects US monetary policy developments and heightened Middle Eastern turbulence. Sharp dollar appreciation in the past has often contributed to heightened protectionist pressures, a force already overly and unfortunately present in current US policy and discourse.

Let’s hope US and global policy-makers focus on fixing the underlying fundamental determinants of exchange rates and don’t shoot the messenger.

Mark Sobel is US Chair of OMFIF.

These themes will be further explored in the upcoming edition of OMFIF’s Global Public Investor 2024.

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