Will the dollar also be ‘higher for longer’?

Since July, the pound has slipped from $1.31 against the dollar to $1.22. as the chart shows. This rather dramatic decline has prompted some unfavourable comparisons with last year’s ‘mini’-Budget fallout, which saw the pound plunge to $1.04. 

This time, the drivers are very different: instead of doubting the credibility of the UK government, markets are now grappling with the question of where interest rates will be 'higher for longer'. Earlier this summer, the answer looked obvious. In July, UK inflation was stuck at 8.7 per cent but had fallen to 4 per cent in the US. With UK price growth proving so stubborn, it seemed almost certain that the Bank of England (BoE) rate-setters would need to raise rates higher (and keep them there for longer) than their US counterparts. 

But since then, the outlook has changed: UK inflation is now falling convincingly, and policymakers are satisfied that higher interest rates are starting to weigh on the economy. Earlier this month, Matthew Ryan, head of market strategy at financial services firm Ebury, said that his optimism on sterling had been “tempered in recent weeks” given that rate hikes deeper into 2023 are “not necessarily on the cards”. 

Meanwhile, across the Atlantic, a higher-for-longer narrative has firmly taken hold. In September’s meeting, Federal Reserve policymakers released projections suggesting that US interest rates would average 5.1 per cent over 2024 – up from the 4.6 per cent forecast in June. Even more surprisingly, updated ‘dot plots’ also implied the possibility of a further rate hike before the end of the year. 

As it stands, markets aren’t quite convinced. At the time of writing, investors see around a 10 per cent chance of a further hike in the November meeting, according to the CME FedWatch tool. Yet there is no denying that the US economy looks resilient. Earlier this month, the October jobs report caught everyone by surprise, showing remarkably strong payroll growth in August and September. As a result, markets are coming round to the idea that the Fed will not be in a position to cut rates as quickly as we once expected. 

The impact of higher-for-longer US rates has been felt in bond markets too, and the 10-year Treasury yield has risen above the 10-year gilt yield (see table) for the first time in over six months. The DXY US dollar index strengthened from below 100 in July to 107 by the start of this month, with the strong run bringing the dollar to its highest level since last December. 

But the dollar could easily be derailed as expectations shift again. Analysts at Capital Economics think that markets have overreacted to the Fed’s mantra, and believe that the US will be the first economy to declare victory in the fight against inflation after all. Their forecasts suggest that the Fed will be in a position to cut interest rates months before the BoE (the first half of 2024 compared with late 2024), which means that interest rate movements will start supporting the pound again.

It is also worth stressing that interest rates are not the only driver of exchange rate movements – especially where the dollar is concerned. The greenback's status as the world’s reserve currency means that it is a beneficiary of ‘safe-haven’ flows, especially at times of turmoil. Following the outbreak of war in Israel earlier this month, Fiona Cincotta, senior financial markets analyst at City Index, noted that “the pound is heading lower in risk-off trade while investors are favouring the safe-haven US dollar”. 

Similar dynamics could come into play again if the economic outlook darkens next year. Economists are split on whether the US, UK and eurozone will enter recession, especially as the impacts of this year’s interest rate hikes start to feed through. Analysts at Capital Economics expect all three regions to contract next year, triggering safe-haven flows that would strengthen the dollar. If they are right, the pound could end the year at $1.20 – and stay there for most of 2024.