The U.S. dollar had its moment last year when inflation was soaring to 40-year highs, the Federal Reserve was responding with aggressive interest rate hikes, and investors, generally, were recoiling from risky bets on stocks. Those days are over.
The U.S. dollar, which hit a record high against a basket of major global currencies in October, this week dipped to its lowest level in more than a year, falling below technical levels that had previously offered support.
There’s a good chance the currency’s downward slide will continue, offering a particularly profitable tailwind to investments tied to base metals and other commodities, which tend to gain in value as the U.S. dollar declines.
For Canadian investors, a lower dollar means U.S. stocks are cheaper to buy in Canadian-dollar terms.
“U.S. exceptionalism – superior growth, higher interest rates – has really been the story of dollar strength over the past few years,” said Shaun Osborne, chief FX strategist at Bank of Nova Scotia.
Now, though, “dollar strength is probably going to turn into a sustained period of dollar weakness,” Mr. Osborne said.
The next few months could be especially challenging for the dollar, he believes, owing to seasonal factors and continuing reaction to Fed policy.
Other currencies should gain in strength. Mr. Osborne expects the Canadian dollar could rise to a range between 78 and 79 US cents over the next two or three months, up from 75.7 US cents on Friday afternoon. The loonie could rise further in 2024, moving above 80 US cents.
The key reason the U.S. dollar is suddenly looking more vulnerable: This week’s reading on U.S. inflation was surprisingly tame after more than a year of eye-popping surprises.
The U.S. consumer price index for June increased just 3 per cent, compared with last year. That’s the lowest headline reading, which includes volatile food and energy items, since March, 2021. It marks a massive shift from exactly a year ago, when prices were up an astounding 9.1 per cent, and offers a compelling case that the Fed’s string of rate hikes since then is having a significant impact.
Economists still expect the Fed to raise its key rate in July. However, financial markets are reflecting bets that the current rate-hiking cycle will likely end after that.
“When the Fed released its summary of economic projections, it had two rate increases by the end of the year – one in July and one presumably after that. But the market said: Uh-uh, we don’t think that second one is going to happen,” said Michael Gregory, deputy chief economist at BMO Capital Markets.
“More importantly, the market is starting to factor in interest-rate reductions for the first part of next year. The landscape has changed in terms of the market’s expectations,” Mr. Gregory said.
Now, with a new outlook of moderating inflation and a potential shift in central bank monetary policy, investors are taking a deeper interest in riskier assets, such as stocks. The S&P 500 gained further ground this week and reached its highest level in well over a year, extending the bull market that began in October.
Among commodities, crude oil rallied above US$75 a barrel, reaching its highest level since May. Copper, an economically significant base metal tied to industrial uses and expanding electrification, hit a three-month high of US$3.95 a pound this week, up from a recent low of US$3.70 at the end of June.
What’s next?
Despite this week’s encouraging reading on U.S. inflation, it remains a threat and well above the Fed’s target of 2 per cent. That means investors will be paying a lot of attention to incoming economic data as they parse whether the central bank will indeed make its final rate hike in July.
The U.S. dollar may be susceptible to weaker economic data that confirms the market’s suspicions that further rate hikes beyond July are no longer necessary. The monthly U.S. payrolls numbers may be especially important here.
“Softer economic data are just going to persuade markets, even more, that the Fed has little or no more work to do,” Mr. Osborne said.
Nonetheless, the dollar’s downward trajectory relies on investors remaining somewhat optimistic about the health of the global economy. A slowdown is one thing, but a severe recession or a nerve-rattling geopolitical event could send investors running back to the U.S. dollar, which is perceived as a safe-haven currency.
“That doesn’t necessarily have anything to do with monetary policy, but very much has to do with the U.S. dollar as a barometer of the global economy,” Mr. Gregory said.