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Bonds
January 10, 2024 Kathy Jones
With the Federal Reserve poised to begin cutting interest rates this year, the dollar may drift generally downward. However, its performance against individual currencies may vary widely.
We expect 2024 to be a year of diverging trends for the dollar. It will likely move lower on a broad trade-weighted basis early in the year but stabilize as the year progresses. Although we expect a general downward drift for the dollar, performance of individual currencies will likely vary widely. For those investing internationally, it means that there is opportunity when allocating to foreign markets, but it will be important to be selective. Currency fluctuations can affect returns—either positively or negatively.
The key driver of the dollar's direction should be monetary policy. In 2024, central banks around the world are poised to cut interest rates. Among the major developed markets, the Federal Reserve is expected to lead the rate-cutting trend. Consequently, the dollar will likely continue to fall moderately as the yield differences between the U.S. and other countries shrink. However, we don't expect a steep drop and look for performance to diverge when compared to various currencies.
Trade-weighted dollar likely to decline as U.S. interest rates fall
One of the challenges in talking about the outlook for "the dollar" is defining what measure of the dollar to use. With floating exchange rates, the dollar can and does move in many directions at the same time.
We tend to look at the Federal Reserve's broad trade-weighted index for an overall measure of the dollar's direction. Because the index is weighted by the value of trade with other countries, it is a way to assess the strength or weakness of the dollar based on its usage. However, it doesn't always consider other forms of demand for the dollar, such as investment or safe-haven demand, and a broad index may obscure the dollar's performance against individual currencies within an overall trend.
Nonetheless, a trade-weighted index can be a useful benchmark for measuring the dollar's trend because it gives a broadly diversified snapshot of the dollar's value and captures the largest trading partners for the U.S. among emerging-market countries as well as the major developed-market countries. The currencies of six countries or areas dominate the index, as those are the largest trading partners for the U.S.
Six countries or areas dominate the Fed's trade-weighted U.S. dollar index
Source: Board of Governors of the Federal Reserve System. Foreign Exchange Rates. U.S. Fed Trade Weighted Nominal Broad Dollar Index (USTWBGD Index). Trade weights as of 12/18/2023.
The Federal Reserve's Trade-Weighted Nominal Broad U.S. Dollar Index is a weighted average of the foreign exchange value of the U.S. dollar against the currencies of a broad group of major U.S. trading partners, including Canada, China, Japan, Mexico, the UK and the eurozone. The "others" category consists of the following countries: Australia, Argentina, Brazil, Chile, Colombia, Hong Kong, Indonesia, India, Israel, Korea, Malaysia, Philippines, Russia, Saudi Arabia, Sweden, Singapore, Switzerland, Taiwan, Thailand, Vietnam.
The dollar began to fall in the middle of last year. After reaching a more than 10-year high in 2022 that saw it move up by nearly 50% from the 2011 low, the dollar has retraced about 10% from its peak. It is still higher than its five-year average.
The U.S. dollar is down from its peak in 2022
Source: Bloomberg. U.S. Fed Trade Weighted Nominal Broad Dollar Index (USTWBGD Index). Daily data as of 1/8/2024.
Past performance is no guarantee of future results. Indexes are unmanaged, do not incur management fees, costs, and expenses and cannot be invested in directly.
One of the key drivers behind the dollar's strength in the past few years has been the relative strength of the U.S. economy and high interest rates. As the Fed signaled it was pausing interest rate hikes last fall, the dollar began to pull back. As we expect the Fed to shift to cutting interest rates in mid-2024, interest rate differentials should narrow, reducing the appeal of holding dollars. Nominal U.S. interest rates are still higher than those in most other G10 countries, but the difference has been narrowing.
Current nominal interest rates by country
Source: Bloomberg, data as of 1/3/2024.
Fed=The Federal Funds Rate Upper Target, BOE= The Bank of England Official Bank Rate, BOC=Bank of Canada Overnight Lending Rate, ECB=The European Central Bank Deposit Facility Announcement Rate, BOJ=The Bank of Japan Policy Rate Balance Rate (FDTR Index, EUORDEPO Index, UKBRBASE Index, BOJDPBAL Index).
Nominal U.S. interest rates are still higher than those in most other G10 countries
Source: Bloomberg, data as of 1/3/2024.
The G10, or Group of 10, consists of 11 industrialized countries that meets annually to discuss international financial matters. The member countries are Belgium, Canada, France, Germany, Italy, Japan, the Netherlands, Sweden, Switzerland, the U.K. and the U.S. Fed=The Federal Funds Rate Upper Target, BOE=The Bank of England Official Bank Rate, BOC=Bank of Canada Overnight Lending Rate, ECB=The European Central Bank Deposit Facility Announcement Rate, BOJ=The Bank of Japan Policy Rate Balance Rate (FDTR Index, EUORDEPO Index, UKBRBASE Index, BOJDPBAL Index).
However, continued dollar weakness depends on a rebound in economic growth in other countries along with relatively tighter monetary policy. Recently, economic growth has been disappointingly slow in Europe and the U.K. Consequently, the Bank of England and European Central Bank may cut interest rates in concert with the Federal Reserve. If that occurs, then the dollar would likely regain lost ground against the British pound and euro from current levels. This is especially true if the U.S. economy remains resilient.
The dollar has lost ground against the euro and pound since January 2022
Source: Bloomberg. Euro US Dollar Exchange Rate (EURUSD Index) and Sterling and US Dollar Exchange Rate (GBPUSD Index). Daily data as of 1/8/2024.
Past performance is no guarantee of future results.
On the other hand, the Bank of Japan has indicated that it is ending yield curve control and will likely raise short-term interest rates from negative levels in 2024 for the first time in decades as inflation picks up. That leaves room for the Japanese yen to appreciate as domestic investors repatriate money that has been invested abroad. Since Japan is a large net investor in U.S. Treasuries and other securities, a shift toward domestic investing could come at the expense of the dollar.
A bullish case can be made for the Mexican peso, as well. Mexico has benefited from inflows of foreign investment as U.S. policies encourage production moving closer to home. Consequently, economic growth has been relatively firm, and the central bank has kept the policy rate high despite easing inflation pressures. Real interest rates—adjusted for inflation expectations—are running at about 4.5% based on 10-year government inflation-linked bonds, which many investors will likely find attractive.
Emerging-market currencies may benefit from U.S. rate cuts
Easier monetary policy in the U.S. has often been positive for emerging-market (EM) currencies in the past, especially those with high amounts of U.S. dollar-denominated debt. We would expect that to be true in 2024. Lower U.S. interest rates can provide stimulus for the global economy, reduce high debt burdens, and make investments in EM countries look more attractive. That has been the case over the past six months as the Fed's tone has shifted from a tightening bias to a neutral or easing bias. We expect EM currencies to continue to benefit from easier monetary policy in the major G-10 countries, but, just as in the case of major developed market currencies, the outlook is mixed.
Nominal Emerging Market Economies U.S. Dollar Index
Source: Board of Governors of the Federal Reserve System (US), Nominal Emerging Market Economies U.S. Dollar Index (TWEXEMEGSMTH). Monthly data as of 12/29/2023.
The Federal Reserve's Nominal Emerging Market Economies U.S. Dollar Index tracks the value of the U.S. dollar against a basket of emerging-market currencies. Chart is indexed to 100 in 2006. Past performance is no guarantee of future results. Indexes are unmanaged, do not incur management fees, costs, and expenses and cannot be invested in directly.
The EM universe varies widely from countries that are primarily commodity exporters to those that have large service-sector economies, making it difficult to generalize on the direction of their currencies. It's worth noting that yields vary widely, as well. Among the countries that issue debt in their own currencies, China dominates. It has a managed currency and relatively low yields. Among EM countries that issue debt in U.S. dollars, yields are much higher, but come with considerable economic and political risk, which tends to limit investor appetite to the riskier issuers.
Look carefully amid the volatility in 2024
Overall, the dollar appears likely to drift lower on a trade-weighted basis in the first part of the year as long as the Fed is signaling it will lower interest rates. However, the dollar's downside is likely to be limited, as other central banks are expected to begin easing by mid-year. While a lower interest rate environment is generally favorable for emerging markets, the risk spectrum is wide. For investors, allocating to international investments can provide diversification and opportunities. The key in 2024 is to assess the specific currency exposure and degree of exposure that's appropriate.
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