by Economist
The dollar is enjoying a rare period of strength. How far can the rally go?
VISITORS to America this summer will find their money does not stretch quite as far as on previous trips. The dollar has risen this year against a broad range of currencies, so holiday purchases will be a bit pricier than usual. A strengthening dollar is a rare thing. The upward bursts in the early 1980s and the late 1990s were deviations from a generally falling trend. Since it was freed from the Bretton Woods system of fixed exchange rates four decades ago, the dollar has mostly fallen in value against other rich-world currencies. But a growing band of analysts reckon it is time for the greenback to regain a bit of lost ground.
The immediate spur for optimism about the dollar is the recent signalling from the Federal Reserve that its purchases of bonds with newly created money may start to tail off as soon as September. The prospect of an end to quantitative easing has already pushed up long-term interest rates. The yield on ten-year Treasuries has risen to 2.6% from a low of 1.6% in May. As yields rise, capital is attracted to America from riskier parts of the world. That in turn pushes up the dollar.
The deeper cause of the dollar rally is the relative health of America’s economy. Bad mortgage debts have been cleaned out of banks. The housing market is recovering. Jobs are growing steadily. Non-farm employers added 195,000 workers to their payrolls in June, in line with the average increase so far this year.
GDP growth has been modest even if it is likely to strengthen a bit. In an update to its projections, the IMF this week forecast that the American economy will grow by 2.7% next year. That is hardly a boom. But other big rich economies, such as Japan and Britain, cannot hope to do nearly as well. And the euro zone is still in recession.
As if to underline these divergent fortunes central banks in Europe indicated earlier this month that looser monetary policy may still be required on their patch. Mario Draghi, the president of the European Central Bank (ECB), said on July 4th that the bank expects to keep its main interest rates “at present or lower levels for an extended period of time”. This was the first time the ECB had given explicit guidance about the future path of interest rates. It came shortly after a statement from the Bank of England’s monetary-policy committee, meeting for the first time under its new governor, Mark Carney, which said the British economy was still too weak to warrant the increases in the bank’s benchmark interest rate implied by recent rises in longer-term bond yields.
The Fed’s own forward guidance about the probable “tapering” of its bond purchases is what pushed up these yields in Europe. As the extent to which monetary policy in America and Europe are on different paths becomes clear, the transatlantic gap in market interest rates is likely to widen. The dollar ought to rise further.
Still shallow
But how much further? For now a fitful upwards grind of 5-7% against the other major currencies might well be the limit. America’s economy is doing well enough to give its currency a boost, but it is not yet so strong as to spur the sort of bull run the dollar enjoyed in the late 1990s. Even if the Fed dials back bond purchases soon, it might be years before it raises its benchmark interest rate from near zero. The Fed has said it will stay where it is until unemployment, now 7.6%, has fallen to 6.5%; on July 10th Ben Bernanke, its chairman, said the rate could stick at near zero long after that. And the Fed would itself react to a fast-rising dollar: no rich country is keen to have a strong currency when growth is scarce. That is why the dollar rally will be a shallow one, says Kit Juckes, an analyst at Société Générale.
There may also be a limit to how far the euro can fall. The euro zone’s sovereign-debt crisis has dragged on for more than three years. Yet in all that time the euro could rarely be described as cheap. And even after the monetary-policy steers from the Fed and the ECB, the euro is still a bit above the fair value of $1.26 suggested by the Big Mac index, our rough-and-ready guide to currencies (see article).
One reason for this resilience might be that euros are harder for foreigners to earn than dollars are: the euro zone has a large current-account surplus whereas America has a big deficit. Another is that China’s central bank may have used any temporary weakness in the euro as an opportunity to diversify its huge reserves away from the dollar. Can the euro get below, say, $1.20? “You’ll have to ask the Chinese,” says a US-based hedge-fund manager.
The dollar seems likely to make the biggest gains against emerging-market currencies. A handful of countries, including India and South Africa, which depend on foreign capital to finance their trade deficits have already seen their currencies fall by around 10% since the beginning of May, merely on the prospect that the Fed might take its foot off the monetary-policy pedal (see chart). As long as bond yields were low in America, rich-world investors were happy to buy emerging-market bonds. But such capital will be a lot harder to secure from America as quantitative easing comes to an end.
Some emerging markets have already reportedly sold a slug of dollars from their foreign-exchange reserves to slow the descent of their currencies. There may be some second-round effects from this as these central banks then replenish their dollar reserves by selling some of their euros. By next summer visitors to America may find the dollar that bit stronger and their wallets emptying that bit faster.
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