Anyone planning a European city break got an added bonus recently when the pound reached a seven-year high against the euro. But sterling is not the only currency on the move in global markets. The most important change is the rise of the dollar, particularly against the euro, which has just hit a 12-year low against the greenback. This trend, which started in earnest in the latter part of 2014, ought to be good news for investors – if the strength of the dollar does not get out of hand.
There were good reasons for the US currency to go up and the euro to head down, including the relative strength of the US economy and the prospect of higher interest rates at a time when the European Central Banks’s monetary policy is getting markedly looser.
There has also been a structural change in the US economy in the form of the discovery of shale energy. That has pushed the US towards energy independence, which has shrunk its need to borrow from the rest of the world and, at the margin, started to push down the global supply of dollars.
Will this trend continue? Forecasting currencies is a dangerous business but we know the ECB would like the euro to continue to weaken. With real and nominal interest rates already at record lows, the currency has emerged as a central tool in its efforts to boost growth in the eurozone and import some inflationary pressure from the rest of the world.
The ECB’s own models suggest a 10 per cent change in the value of the currency generates a 0.4 to 0.5 percentage point change in inflation. That was working against the central bank for much of 2013 and the first half of 2014, when a rising euro was pulling down European inflation into the low single digits. Now it can hope to see that effect work in reverse – though the fall in the global oil price is likely to partly offset the impact on inflation in the short term.
Falling energy costs have made things complicated for the ECB, pulling inflation into negative territory. But the medium-term effect should be strongly stimulative, with cheaper oil acting like a significant tax cut for European households and firms.
The macro impact of a stronger dollar is more complicated for emerging markets, which are at a very different stage in their economic cycle to the developed world. At first glance, a stronger dollar looks positive for these economies too, since it should give them a competitive boost in US markets, as well as possibly slowing the path to tighter US monetary policy. However, a stronger dollar could also aggravate inflation problems in some parts of the emerging world and suck foreign capital out of those economies and back to the US.
The message is that in currencies, as in life, it is not just what you do but how you do it. A gradual rise in the US dollar is likely to do less harm than a more dramatic period of strengthening, which could cause instability in markets around the world, as well as causing serious headaches for the US central bank.
The lesson of history is that once major global currency trends get under way they can last a long time. For instance, we have historically seen sustained movements of 20 to 30 per cent in the value of the US dollar. This could be the start of a fairly long road.
There is no reason why investors should fear such a long-term trend, if it is primarily a result of the US growing faster than the rest of the world. But it would be a problem for the US and the rest of the world if the dollar became a “one-way bet” for investors.
Luckily, the risk of such a rush into US assets does not seem as large today as it did at the start of the year, when the US recovery story seemed to be the only one global investors had any confidence in. Since then the start of full-scale bond purchases – quantitative easing – by the ECB and positive news from the real economy has made investors look much more favourably on European assets. We are also seeing investor unease about the negative consequences of dollar strength for the foreign earnings of US companies.
This shift in relative confidence is healthy and could work to investors’ advantage if it introduces some uncertainty into currency markets. The underlying strength of the US economy relative to Europe and the prospect of tighter US central bank policy are likely to be important supports for the US currency for some time to come. But if the dollar is indeed headed higher this year it would be healthier for global markets if it took some time to get there.
Stephanie Flanders is chief market strategist for UK & Europe at J.P. Morgan Asset Management