What the dollar’s historic rise means for markets as stocks and bonds end brutal first half

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2022 will be a historic year for markets including the world’s reserve currency.

As the S&P 500 headed for its worst first half in more than 50 years, the U.S. dollar posted its biggest appreciation in history in the first six months of 2022, according to some indicators.

The Fed’s decision to raise interest rates by 75 basis points in June to follow what Capital Economics called the most aggressive monetary tightening since the 1980s sent USD/JPY down -0.73% in the first quarter, up 17% half a year. According to data from the early 1950s, this was the largest such move in USD/JPY history, according to Dow Jones Market Data.

The dollar rose 0.34% against the euro’s other main rival, EURUSD, which has gained more than 7% so far this year – its strongest first half since 2015, when Greece’s economic crisis sparked concerns about what could happen. Concerns about the economic crisis. The euro zone collapsed.

Measuring the dollar’s strength from a broader perspective, the Wall Street Journal Dollar Index BUXX -0.36%, which includes 16 competing currencies to calculate the value of the greenback, is up 8% so far this year and posted its biggest appreciation in the first half of the year since 2010.

In foreign exchange, intraday volatility is typically measured in basis points, and macro strategists told MarketWatch that moves of this magnitude are more common in emerging market currencies than in G-10 currencies like the U.S. dollar.

But why is the dollar rising so aggressively? What does a stronger dollar mean for stocks and bonds heading into the second half of 2022?

What’s driving the dollar up?

The dollar has benefited from two tailwinds this year as inflation hit a 40-year high.

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The bottom line, according to a handful of Wall Street currency strategists, is that the interest rate gap between the U.S. and the rest of the world is widening. Dozens of other central banks, including the European Central Bank, have decided to follow in the Fed’s footsteps by raising interest rates or planning to do so. U.S. real interest rate – i. H. However, inflation-adjusted bond and bank deposit yields remain more attractive, especially compared with Europe, where inflation is more pressured, and the European Central Bank only recently announced plans to raise interest rates from July.

In Japan, where inflationary pressure is relatively moderate, the Bank of Japan bucked the trend of global monetary tightening, continued to implement the yield curve control policy, and bought a large number of Japanese government bonds.

But favorable interest rate differentials aren’t the only thing driving the dollar higher: the greenback also benefits from its new-found “safe haven” status.

According to a model developed by Steven Englander, global head of G-10 currency strategy at Standard Chartered Bank, 55% of the dollar’s appreciation this year can be attributed to interest rate differentials (and more importantly, interest rate differentials). Monetary Policy). U.S. politics compared to other developed nations), while the other 45% is driven by the trend of risk aversion.

Englander and his team developed the model by comparing the dollar’s performance to synchronized movements in government bond and U.S. stock yields.

“Since mid-March, the most reliable indicators of dollar strength have been rising interest rate spreads and falling S&P,” Englander described his model in a recent research note.

The S&P 500 SPX index -1.25% fell sharply. The index is down nearly 20% so far this year as of Wednesday, putting it on track for its worst first-half performance since 1970, according to Dow Jones Market Data. The Dow Jones Industrial Average was -1.20%, down 14.6% over the same period, the worst performance among its peers since 2008.

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Investors aren’t finding safety in government bonds as yields on government bonds, which are inversely proportional to price, are rising sharply as the Federal Reserve seeks to aggressively tighten monetary policy.

But even as stocks fell and bonds rose (bond prices are inversely related to yields), the dollar mostly continued to appreciate. The pattern is clear: The U.S. dollar has benefited since the start of the year as markets have turned to safety.

“This may be because both U.S. and foreign interest rates tend to move in the same direction when risk appetite – for example, due to the Russia-Ukraine war – pushes the dollar higher. So it may not be clear whether the spread is widening or narrowing, but the dollar is very Likely to respond to changes in risk rather than spreads,” Englander said.

Historically, this trading pattern is anomalous and whether it will continue into the second half of the year is debatable. As the Fed insists on responding to developments in growth and inflation when the data comes out, expectations for the Fed’s plan will continue into the fall, said Marvin Loh, senior global macro strategist at State Street Bank.

“Right now, we’re expecting the (Fed rate hike) to be done in the next 9 or 12 months. If not, you get a continuation of the story,” Loh said.

Over the past week or so, moves in derivatives markets have suggested that investors are beginning to wonder if the Fed will raise rates by at least 350 basis points this year. The central bank has raised the ceiling on the federal funds target rate to 1.75%, with the “median” forecast target rate between 3.50% and 3.75%, according to the latest “dot plot” published in June. next year.

However, fed funds futures, a derivative that investors use to bet on the direction of the benchmark rate, are already pricing in a July 2023 rate cut.

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The recent -3.73% drop in CL00 crude oil prices and other commodities – sharp falls in the price of industrial metals and even wheat – have dampened inflation expectations to some extent. However, if inflation persists longer than expected, or the U.S. economy resists slipping into recession, expectations for the pace of Fed rate hikes could change again.

On the other hand, as other central banks scramble to catch up with the Fed — 41 of the 50 central banks covered by Capital Economics have raised rates so far this year — spreads between the Fed and its rivals are increasingly likely Rival central banks will expand and may start to pull back.

As for other central banks, perhaps the biggest question here is whether the Bank of Japan and the People’s Bank of China can end their easy monetary policy.

Neil Shearing, chief economist at Capital Economics, said recently that the BOJ is more vulnerable to capitulation than the People’s Bank of China in terms of policy.

Shearing said that if the BOJ continues to buy bonds at these rates to defend its JGB yield cap, it will have the entire Japanese government bond market (the world’s largest by total issuance) within a year. one).

Consequences of a stronger dollar

But there are also a number of domestic factors that could influence the direction of the dollar. As inflation persists and the U.S. economy begins to slow — a “fast” reading of the S&P Global Composite PMI in June showed economic output slowing to its lowest level since the omicron-induced slowdown in January — it’s important to Remember, just a few years ago, the macroeconomic environment was very different.

In the 2010s, central banks around the world aimed to keep their currencies weak in order to make their exports more competitive, while introducing a degree of inflation.

Now, the world has entered what Steven Barrow, head of G-10 strategy at Standard Ban, calls a “reverse currency war.” Today, a strong currency is more popular because it acts as a buffer against inflation.

As the world’s reserve currency, a strong dollar is a problem faced by both developed and emerging countries. While the U.S. economy is relatively immune to financial stress from a stronger dollar, Barrow worries that if it continues to strengthen, other economies could face “some embarrassing problems,” including worsening inflationary pressures or a potential currency crisis, such as covering East Asia and Southeast Asia in 1997.

But will the dollar’s strength continue in the second half of the year? Analysts and economists disagree. Jonathan Petersen, a market economist at Capital Economics, said he thinks the global economic slowdown means the dollar could have more room to rise, especially after the recent pullback.

On the other hand, Englander sees the dollar losing some of its gains in the second half of the year.

He suspects a return to risk appetite could drive the S&P 500 higher in the second half, while a reversal of safe-haven flows and narrowing spreads could help erode some of the dollar’s strength.

However, “earnings pessimism” sparked by a U.S. recession could weigh on stocks and support the dollar, while “soft landings” such as the Federal Reserve are designed to cushion stocks while potentially triggering some dollar reversion.

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