- Interest rates will move FX markets this year
- But could structural forces keep the dollar afloat?
As the Federal Reserve cuts rates this year, the consensus is that the dollar will weaken. After all, movements in currencies and interest rates are intimately linked: higher rates attract investors, driving demand for a currency and increasing its value. Rate cuts should have the opposite effect.
We saw this relationship in action after January’s Fed meeting. Chair Powell said that March rate cuts were not the ‘base case’ and the dollar rallied as investors pushed bets for the first rate cut back to May. But although the pushback offered some support to the dollar, it could prove short-lived.
John Canavan, US analyst at Oxford Economics, expects the US central bank to “help lead the decline in global policy rates”. This will diminish the dollar’s attractiveness, and Canavan thinks that the dollar will gradually weaken as US interest rates are cut to a less restrictive level this year.
Economists at Dutch bank ING also “sympathise with the increasingly consensus view that the dollar will trend lower in 2024”. They expect the dollar to weaken, with the pound strengthening from $1.23 to $1.28 against the over the next 12 months. But sterling's value isn't only a dollar story. After all, the exchange rate tells us the price of pounds in terms of dollars – and it will be influenced by factors on this side of the pond, too.
Interest rates aren’t everything
Forecasts from ING analysts imply that pre-election tax cuts could equate to 0.3 percentage points of UK gross domestic product (GDP) growth this year, delivering a boost to aggregate demand. This would worry Bank of England rate-setters, who remain highly attuned to any signs of inflationary pressure building up. Tax cuts could mean higher for longer interest rates – and a stronger pound as a result.
Of course, interest rates aren’t the only thing that impact exchange rates. The messy business of politics – and geopolitics – will also have an impact this year. There remains a risk that conflict in the Middle East could escalate, or that we will see another energy price shock. If so, investors could flock to the dollar as a safe haven. In this scenario, analysts see it outperforming both European and Asian currencies. This only highlights that if you’re the world’s dominant currency, slightly different rules apply.
Despite speculation about the dollar's demise, there is not really a credible alternative. Much of world trade still takes place in dollars, and it still makes up the bulk of foreign currency reserves. As a result, Barclays analysts think that there are long-term, structural reasons to believe that despite the long-term ascent of the dollar against currencies like sterling (see chart), the former is really “far less expensive than often perceived”.
Dollar dominance has long, and deep roots. More recently, the US’s policies have shielded the US economy from the energy shocks that have blighted the UK and Europe over the past two years. These policies have also left it less vulnerable to declining globalisation and the impacts of economic fracturing. Barclays analysts think that over the same period, China and Europe have been relatively neglectful of their domestic markets, exposing them further to “declining global growth dynamics”. The US has been rewarded with large inflows into the dollar as a result.
According to the analysts, these structural forces “not only explain the steady grind higher in the US dollar; they also presage the extension of this drift”. Although the dollar could be rocked by macroeconomic events and policy changes as the election approaches, economists note that the sheer size of the US economy leaves it well placed even if it does take a more isolationist path. The dollar’s strength can’t be taken for granted – but it looks as though it will take more than rate cuts to weaken the greenback.
