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OPINION

Updated January 9th, 2024 at 22:34 IST

Imperial dollar is impervious to lower rate hopes

The dollar has begun 2024 on a tear despite expectations for big cuts to the benchmark US rate.

Dollar hits three-month low
Dollar hits three-month low | Image:Unsplash
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Dollar stored. You can’t keep a dominant currency down. The dollar has begun 2024 on a tear despite expectations for big cuts to the benchmark U.S. rate. Borrowing costs will drop further if inflation continues to abate. But the United States’ inner economic strength in a slowing world, and the greenback’s vital role in finance and commerce, will keep the currency afloat for a while.

The relationship between a fiat currency and the interest rates of the country backing it can often be tortured. But conventionally speaking, currencies tend to strengthen when rates rise and weaken when they fall. The dollar is flipping the script. After losing 2.1% in 2023 as rates rose dramatically, the Dollar Index, which measures the greenback’s performance against a basket of six major currencies, is up 1% so far this year, despite widespread expectations of rate cuts in 2024. Last week was the index’s best since July, according to Deutsche Bank.

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Some of this strength is technical. Employment data in the first week of the year pointed to a strong economy, prompting some traders to reduce their forecasts of swift rate cuts. But markets still expect the Federal Reserve to reduce borrowing costs seven times in 2024, bringing rates to around 4% from 5.25%-5.5% now, according to derivatives prices collected by LSEG. That should push investors away from the greenback.

Yet three other forces are pushing in the opposite direction. The first is what Fed staff called the “Imperial Circle”. High U.S. rates push up the value of the dollar. That makes it more expensive for non-U.S. companies to trade. As a result, global growth slows. Because the U.S. economy is less dependent on the rest of the world - trade volumes were 30% of U.S. GDP in 2022, compared to 100% in Germany and 47% in Japan, according to the World Bank – it fares better than others. That increases the allure of dollar-denominated assets, boosting the currency.  This cycle is playing out right now. Global growth will slow to 2.9% this year, well below the 3.8% it averaged in the two decades to 2020, according to the International Monetary Fund. Yet the United States will grow faster than rivals such as the Germany, France, Britain and Japan.

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The second factor boosting the dollar is that, if the Fed manages to bring inflation down without a contraction in the economy, rate cuts could prompt a rally in U.S. stocks and bonds, sucking up demand from the world’s savers. Indeed, the Dollar Index has risen in three of the last five rate-cutting cycles, according to Capital Economics.

Third, any external shock, such as a worsening of the already dire situations in Ukraine, Palestine and the Red Sea, would send investors scurrying to the greenback as a safe haven. Given the fragility of the global economy – and the dollar’s role as its vital cog –the U.S. currency’s strength is here to stay.

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Published January 9th, 2024 at 22:34 IST

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