It goes up when things are good and it goes up when things are bad, so it’s a fair question to ask under what circumstances the US currency ever actually goes down. When everyone seems to accept that the Federal Funds rate will stay higher for longer, just what will it take to reverse an appreciation trend that is beginning to look more secular than cyclical?
The short answer is that there are lots of things that could reverse the current trend. It’s just that very few of them seem likely anytime soon.
Figure 1. What will it take to bring the dollar down?
Source: Board of Governors of the Federal Reserve System
Note: Shaded areas indicate US recessions
Of course, there are the very short-term factors that could reach consensus. A new cycle of Federal Reserve speak could turn cumulatively more dovish. Recent Bank of Japan interventions to strengthen the yen could start to work. Or there could be fresh reports that China is speeding up gold purchases to reduce its dollar holdings.
But these headlines come and go too fast to trade.
Then there are the very long-term factors that could weaken confidence in the dollar. Topping this list is a dysfunctional political system that seems to be losing control over its debt dynamics. Running a close second is a current account that has not been in lasting surplus since the 1970s. Then there’s the polarization and mistrust of the ‘deep state’ that threatens to politicize the courts, regulators and institutions that underpin the world’s deepest and most sophisticated capital markets.
But these trends are much too slow to trade.
So, the savvy investor will have an eye on the dynamics of the fundamentals. Most obviously, US growth could falter as the sharpest tightening of financial conditions in decades finally catches up with homeowners and corporate borrowers. (No, really!) This could trigger a sustained outflow from dollars if weaker US data land amid signs of stronger growth elsewhere. Euro area business activity just registered its fastest pace in a year, and Chinese manufacturing and services continue to expand in spite of frustrations over the government’s timid measures.
More likely is a shift in expectations around rates over the next 12 months. Just as hot data since January priced out Fed rate cuts this year, cooler inflation reports over the summer could easily price them back in by December. And while the European Central Bank insists it makes its decisions based on Europe’s own price dynamics, it doesn’t want to get too far off the Fed’s rate cycle, especially as it surveys that recent disastrous performance of the yen. Higher for longer euro rates could divert interest in the dollar.
Trade flows should ultimately determine exchange rates, but those dynamics are hard to predict. The US current account deficit has closed significantly since the pandemic but shows few signs of moving towards balance while the consumer’s appetite for lawn furniture and iPads persists. (The strong dollar makes these imports even more attractive.)
A second Donald Trump administration that slaps large tariffs on imports could help close the deficit, which would boost the dollar all else being equal. Were America to cut taxes and restrict immigration at the same time, however, the combined inflationary fears might trigger a dollar sell-off. Meanwhile, questions raised by Trump about Washington’s commitments to its allies could raise similar doubts about the dollar as a long-term store of value.
If you see most of these scenarios as far-fetched, you are clearly not alone. But remember that for everyone buying a dollar at current exchange rates, there is also someone selling it. The best returns lurk just outside consensus amid outcomes that are unlikely, but still eminently possible.
Christopher Smart is Managing Partner of Arbroath Group and writes the ‘Leading Thoughts’ column on Substack.
This is an edited version of the article that appeared on Substack.
