The U.S. dollar surrendered its status as the world’s premier safe haven in Q4. Here’s how.
The U.S. dollar’s status as one of the few dependable safe havens for investors during this year’s market mayhem started to erode during the fourth quarter, even as the greenback posted its biggest yearly advance since 2015.
For much of the year, the dollar’s strength was blamed for helping to weigh on stocks, as a more expensive currency ate into export revenues and corporate profits while higher Treasury yields made bonds increasingly attractive relative to stocks.
But something changed for the dollar around the beginning of the fourth quarter. Central banks in Europe and — more recently — Japan applied a more aggressive monetary policy, signaling that they intend to close the gap with higher U.S. yields created by the Federal Reserve. This helped to drive their currencies higher.
At the same time, investors in the U.S. were betting that the Fed’s campaign of interest rate rises was drawing nearer to its end.
This resulted in the euro
rising roughly 8.8% against the dollar, its biggest quarterly gain since 2010, according to Dow Jones Market Data.
Meanwhile, the ICE U.S. Dollar Index
a gauge of the dollar’s strength against a basket of six major currencies, is on track to fall 7.7%, its biggest quarterly drop since the second half of 2010, Dow Jones Market Data show. The yen
and British pound
also strengthened, along with many emerging markets currencies, and in the span of a single quarter, the dollar’s year-to-date advance was cut almost in half.
Despite this, the dollar index still rose 7.9% this year, its biggest calendar-year gain since 2015, when it rose 9.3% amid the eurozone debt crisis that stoked fears that the Greeks might abandon the euro.
Just before the start of the fourth quarter, the dollar index reached 114.11, its highest settlement level of the year, on Sept. 27, according to FactSet data. At that point, the popular gauge of the dollar’s value was up roughly 19% for the year.
Currency analysts have blamed this shift on two things. One is the perception that inflation in the U.S. has begun to cool, easing the pressure on the Fed to be so aggressive with its interest rate rises.
“…[I]nflation and growth are declining in the U.S. and if that continues it’ll make additional Fed rate hikes less likely,” said Bipan Rai, global head of FX strategy at CIBC, in a research note from earlier in the quarter.
At the same time, the European Central Bank has hinted that it’s far from done hiking rates, while investors cling to hopes that the Fed’s first rate cut could arrive in 2023, even though the Fed’s latest “dot plot” forecast suggested the first cut won’t arrive until early the following year.
The ECB raised it base rate by 50 basis points two weeks ago just after the Fed delivered a similar hike, but unlike the Fed, ECB chief Christine Lagarde and other senior policymakers have signaled that they are far from finished with their rate hikes.
“…[T]he Fed is near the end of its rate hike campaign, and according to markets, even closer than it currently thinks. Second, the ECB appears to be making a run for the title of ‘most hawkish major global central bank’ as ECB Governing Council members have been a hawkish,” said analysts at Sevens Report Research in a recent note.
Heading into 2023, many on Wall Street expect the dollar to continue to weaken.
However, currency analysts offered this caveat: whatever happens to the greenback may ultimately depend on the Fed. If the Fed maxes out the Fed funds rate at around 5% as expected, it’s possible the dollar could move lower, but if stubborn inflation and a strong U.S. labor market force the Fed to be even more aggressive with its monetary policy, then the dollar could receive a renewed boost.
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