Before US inflation data put a cap on US yields and sent the Dollar packing from its recent highs, US outperformance was the main story in FX markets. An unwavering federal reserve in the face of economic growth and an elevated yet palatable rate of inflation allowed the strong Dollar thesis to wither and conclude. However, the once again retreating US Dollar also gives us an excellent insight into how the market believes the rest of the world will exit the pandemic and what is in store for global economic growth. The logic comes from the Dollar not just as a US currency but as one of the most reliable barometers of the global economy.
When the US outperforms the rest of the world by a significant margin the Dollar can behave like any other currency: rising as the underlying economy’s fortune improves and falling when it is brought into question. However, when the US economy’s growth is part of a broader global expansion it’s link to the Dollar is far less clear and even frequently inverted, with US growth frequently coinciding with a retreat in its currency. The reason for this lies in the US Dollar’s role not only as a reserve currency and the world’s foremost medium of exchange, but in its status as a safe-haven asset and the preferred form of cash worldwide.
When a resilient fed and moderate data aligned early on in April it should have served to cap the Dollar’s advance, not send the Dollar packing entirely back through 1.20 on EURUSD and towards 90 on DXY. The fact that it has tells us that the market is now expecting global growth to be relatively close behind the now-evident economic recovery in the United States. This provides two further signals to the FX market:
Firstly, so long as global growth forecasts remain healthy, the Dollar should continue to release value. The main risks to this hypothesis are spikes in infection in high output territories. The present rate of infections in India are a clear and present form of this risk. Secondly, if the market is pricing a rapid global and more synchronised recovery thanks to the vaccine rollout, emerging market currencies should continue to demonstrate their appeal. Whilst some valuations in emerging market currencies including the Rand are now looking somewhat stretched, this could ultimately give rise to even stronger commodity and emerging market currencies.
Discussion and Analysis by Charles Porter