On July 9 the US dollar index (DXY) slipped under 100 for the first time since April 3, 2022, with cooling US inflation data released on July 12 maintaining the trend of a weaker greenback against a basket of other trade partner currencies.
As of July 14, the dollar was down nearly 13% from last year’s two-decade high and was its lowest level in 15 months. , the softer-than-expected inflation print supports views that the Federal Reserve is nearing the end of its interest rate-hiking cycle.
Gold has risen $22 over the last three days. Source: Kitco
A weak US dollar has many implications, including strong upside potential in long-term bonds, currencies, American companies selling goods and services abroad, and commodities especially gold.
First we need to understand the relationship between interest rates and the US dollar, since the former has clearly been driving the latter, and is expected to continue doing so.
It’s fairly obvious that changes in the federal funds rate — the overnight lending rate controlled by the Federal Reserve — impacts the dollar. When the Fed hikes the FFR, it has a ripple effect throughout the economy, including on government bond yields. Higher yields on US Treasury bills attract investment capital from investors abroad seeking good returns on bonds. But first the investors need to use their home currencies to buy dollars. The result is a stronger exchange rate in favor of the US dollar.
What will happen if the Federal Reserve begins to lower interest rates, which the market consensus sees happening sometime in 2024? The result will be less demand for dollars, weakening the currency, along with a reduction in US bond yields.
Clearly, a weak dollar makes American goods priced in US dollars more competitive in overseas markets. It also makes it cheaper for multinationals to convert foreign profits into dollars. According to Reuters, an analysis of Russell 1000 companies by Bespoke Investment Group showed that the US technology sector generates just over 50% of its revenue abroad.
In times of economic or political turmoil, domestic and foreign investors often buy dollars because they are a safe haven. When the dollar falls, other currencies that were previously weaker become stronger, and therefore more attractive as an investment.
“That sound you hear is the breaking of technical levels across the foreign exchange markets,” said Karl Schamotta, chief market strategist at Corpay, quoted in the . “The dollar is plunging toward levels that prevailed before the Fed started hiking, and we’re seeing risk-sensitive currencies melt up on a global basis.”
If the buck continues to fall, it could favor the dollar-funded carry trade, where dollars are sold to buy a higher-yielding currency, allowing the investor to pocket the difference. Corpay showed, for example, that selling dollars and buying the Colombian peso would have booked a 25% gain year to date, while the Polish zloty has yielded 13%.
In terms of monetary policy, the dollar’s decline is good for some countries as it removes the urgency to support their falling currencies. Among the best examples is Japan, which intervened last year to prop up the yen for the first time since 1998. Interventions typically consist of the central bank buying large amounts of yen using dollar reserves.
Yen weakness is a continuing problem for Japan, which , especially crude oil and natural gas — priced in US dollars. In fact, when adjusted for inflation, Japan’s currency is trading near its lowest level in decades.
However, last week the greenback tumbled 3% against the yen, setting up the biggest weekly fall against the Japanese currency since January.
Michael Cahill, a G-10 foreign exchange strategist with Goldman Sachs, expects any dollar downturn to be shallower than past cycles, but he says , which could be compelled to keep rates higher for longer.
At least one trader quoted by Reuters
A strong dollar may be in the national interest, because it makes imports cheaper, favoring American consumers. The same goes for US businesses that import manufactured goods and services. A high dollar helps to offset their costs and check domestic inflation.
Commodities are the obvious exception. Of 45 that are traded internationally, 42 are priced in dollars. They include crude oil and other hydrocarbons, corn, wheat, soybeans, base metals such as lead, zinc, copper and aluminum, and gold, platinum and silver.
A weak dollar usually means stronger commodities prices. Because the USD is the reserve currency and most commodities are traded in dollars, the value of the dollar is of crucial importance in determining the value of the commodity in question. Take the case of a low dollar. When the dollar drops it takes less of another currency to buy dollars needed to purchase the commodity, so the demand for that commodity will increase, leading to a price increase. The inverse happens when the dollar strengthens.
The case for commodities is bolstered by the fact that we are starting a new “commodity supercycle”.
While no two supercycles look the same, they all have three indicators in common: a surge in supply, a surge in demand and a surge in price.
The new commodity supercycle, however, could look a bit different from the previous ones for one simple reason — an increased focus on climate change.
According to S&P Global, a more aggressive commitment to the energy transition across G-20 nations could also create the conditions for a sustained surge in demand, supply and prices.
Like in the past, commodity supercycles are usually driven by strong demand for raw materials, manufactured materials and sources of energy. The energy transition serves as a major catalyst for all the key inputs to our renewable energy infrastructure, taking demand to levels never seen before.
Demand for copper — the cornerstone for all electricity-related technologies — is set to grow by 53% to 39 million metric tons by 2040, according to . Battery metals like lithium, graphite, cobalt and nickel will see even faster growth, reaching more than three times the current demand levels by 2030, says BNEF, with lithium rising the fastest with a seven-fold increase.
The direction of a weakening dollar is clear, with the Federal Reserve last month after a series of interest rate hikes. If the Fed cuts rates in 2024, it will weigh on both US Treasury yields and the greenback — both positives for gold.
In fact, gold and silver prices have both seen impressive jumps this year, with gold coming within cents of an all-time high, and silver also flirting with price levels last seen a decade ago.
But the precious metals rally, according to some, has only just begun. One analyst believes it’s only a matter of time before gold surpasses double digits on its way to $12,000-15,000 an ounce.
Rozencwajg says the new bull market phase began in the third and fourth quarters of 2022, “and it really revolves around central banks’ behavior as much as anything else. I think it’s going to propel gold much much higher in this leg of the bull market.”
Central banks actually stopping buying gold during covid, with some deciding to sell bullion to pay for social programs necessitated by virus-related economic slowdowns and business closures.
After economic recovery in 2021-22, this behavior changed, with central banks in the aggregate buying more gold in the fourth quarter of 2022 than they had since the world went off the gold standard in 1971. Individually, some countries bought more gold during this period than at any other time. The trend has carried forward into 2023.
“De-dollarization” is another factor driving the dollar lower and gold prices higher.
While there has been plenty of talk of this over the past few years, the fact is there has been scant evidence of countries using currencies other than the dollar for settling international trade transactions. Until now. Among recent examples, France announced it will sell LNG to China priced in renminbi, China will buy soy and iron ore from Brazil denominated in Chinese currency, and crude oil trades between Saudi Arabia and China will be settled outside the dollar.
“Any time you’re going to get a major monetary shock like that, like the end of a reserve currency system and bringing in a new system, I think that’s going to be really good for gold,” says Rozencwajg.
A recent Bloomberg piece is titled, ‘’. The crux of the argument is that historically, US Treasuries maturing in 10+ years have outperformed shorter-dated Treasuries immediately following the last in a series of interest-rate increases. The Fed is , but a poll suggests it will be the final rate hike.
Surveys by two major US banks found investors have increased their exposure to long-dated bonds, with bonds last week posting their biggest gains since March following a report showing consumer prices (inflation) increased at the slowest pace in two years.
While the biggest moves were in short-and intermediate-maturity tenors, investors can reap bigger rewards by purchasing long-dated bonds. According to Bloomberg data,
BlackRock President Rob Kapito told analysts Friday, .
Of course, any discussion of the dollar’s movements would be incomplete without a mention of the state of the US economy. Many now believe the Fed can pull off what was until only recently viewed as impossible, that is, containing pricing pressures without tipping the economy into recession. This is know as “”.
In other words, a soft landing appears to coincide with a weak dollar.
The Bank of International Settlements published a study last year that analyzed 70 tightening cycles between 1980 and 2019 across 19 advanced and six emerging economies.
The paper found that
A third theory supporting the idea of a soft landing and a weak dollar is proposed by the director of currency strategy at Amundi Asset Management, Paresh Upadhyaya.
Current and future weakness in the dollar — the result of much better inflation readings and the subsequent expectation of the Fed putting an end to its interest rate-hiking cycle, potentially even lowering rates — bodes well for a number of asset classes discussed here. They include long-dated bonds, gold and other commodities that tend to gain value on a lower dollar, and of course, other currencies that are suddenly attractive compared to the mighty buck.
Beyond the simple fact of inflation getting closer to the Fed’s 2% target, which would mean “mission accomplished” for the central bank, there is another reason why the organization cannot continue to hike rates to quell inflation for much longer. Hint: it has to do with the debt.
Even when the Fed starts cutting rates, due to the delay of rolling over maturing debt, interest payments will keep going up for the foreseeable future. As , if rates keep rising “higher for longer”, the current weighted average for total outstanding debt will go from 2.76% to 4% in one year:
This gels with a previous AOTH article highlighting the dangerously ballooning interest on the national debt.
It concluded that budget cuts are inevitable; they are needed just to keep the government solvent. Where will the reductions occur? The answer is Social Security and Medicare/ Medicaid. Both programs are unsustainable the way they are currently structured.
Over the next decade, Medicare and Social Security spending are both expected to double. Yet the government has no money in the bank for future expenses and there is no serious proposal to change that.
How high will they have to raise the debt ceiling to afford these expensive, unfunded liabilities? How much interest will have to be paid on this higher debt?
With 17 cents out of every dollar now going to paying the interest on the debt, it won’t be long before debt servicing costs are the biggest line item, surpassing even the true, bloated defence/ war-making budget. And who is to blame? Both the GOP and Dems.