There is a reverse currency war, and America is winning. Again. Just as the U.S. “won” the fight to devalue the dollar after the 2008 financial crisis, now it is winning the fight to strengthen it.
In both cases the Federal Reserve proved the most powerful and most aggressive of the major central banks, and the dollar swung to help it—first down, now up.
The...
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There is a reverse currency war, and America is winning. Again. Just as the U.S. “won” the fight to devalue the dollar after the 2008 financial crisis, now it is winning the fight to strengthen it.
In both cases the Federal Reserve proved the most powerful and most aggressive of the major central banks, and the dollar swung to help it—first down, now up.
The question for investors is whether this is merely part of the essential rebalancing of the global economy, or a big overshoot that might suddenly—and painfully—correct. It’s probably a bit of both.
The scale of the recent move in the dollar is unusual, but it is the level that really stands out. The greenback is just over 1 cent from parity with the euro for the first time since 2002, and the strongest against the yen since 1998. Adjusted for inflation, the dollar has been stronger when weighted against the country’s trading partners only twice, in 2002 and 1985.
The dollar’s been powered up by the combination of economic logic and monetary support.
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The economic logic both drives the dollar move and helps to restore some balance to the global economy. But for many, it hurts.
The economy justifies a strong dollar not because U.S. growth is particularly strong—indeed, data have been very disappointing recently—but because other places are even worse. The most recent jump against the euro and yen was due to the soaring price of natural gas, and the threat that Russian supplies might be cut off altogether. As big energy importers and machinery exporters, Japan and Germany will be particularly hit.
At a very simple level, new investment will be redirected, and the U.S. is attractive as fracking has made it self-sufficient in energy.
“For any industry that’s energy intensive the U.S. just looks better now,” says Jonas Goltermann,
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senior markets economist at Capital Economics. “The U.S. has gained a lot of competitiveness, the terms of trade have improved.”
That shows up in a stronger currency. It is also visible in the economic data, where Japan and Germany both have soaring import costs, driven by energy. Germany in May registered its first trade deficit in goods since 1991, an astounding reversal for a country that usually runs a mercantilist policy of huge trade surpluses.
The strong dollar helps fix the problems, to some extent. If the market is right that Germany faces permanently higher energy costs, it is going to need to rely less on heavy industry and chemical plants powered by cheap Russian gas. A weak euro helps offset the loss of competitiveness, encourages investment in other, less energy-intensive export industries and discourages imports, softening the blow to employment.
Such a dispassionate description misses the pain. A weaker currency makes exports more competitive at the expense of consumers, who can no longer buy so much imported stuff, and boosts inflation when it is already running far too hot. The opposite happens in the U.S.: The strong dollar makes exporting harder and reduces the foreign profits of American multinationals, but makes imported goods cheaper, helping the Federal Reserve fight inflation.
The monetary logic is obvious. Money in the U.S. earns a higher yield than money in the rest of the developed world. The Fed is lifting rates to try to fight inflation, the European Central Bank says it will, but hasn’t yet, and the Bank of Japan says it won’t. Even as expectations for Fed rate increases have been pared back in recent weeks as recession fears grew, eurozone expectations have dropped faster. The wider gap that results between two-year bond yields in the U.S. and Europe supports the dollar.
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Assessing when this has gone too far is hard. Purchasing power parity attempts to compare the cost of items across countries, but often differs wildly from the actual exchange rates—and such differences can last a very long time. The simplest measure is the long-running Big Mac index compiled by the Economist, which shows that the ubiquitous burgers are 42% cheaper in Japan than in the U.S. at the current exchange rate. The euro is less of a bargain for hungry American travelers, but burgers are still cheap.
In the absence of useful fundamental measures, currency traders often rely on drawing lines on charts to try to predict moves, which is little better than gut feel. My feeling at the moment is that yen weakness has gone too far, while the euro at parity makes a lot of sense given the war in Ukraine. Aside from anything else, the yen usually acts as a haven in tough times, but has instead weakened even further as global recession fears rose in recent weeks.
The more stretched an exchange rate is, the bigger, faster and more painful the eventual correction. But without a trigger—a peace deal in Ukraine might restore cheap gas to Germany, or perhaps a dovish turn by the Fed—it is hard to see what could prompt the dollar to turn.
Write to James Mackintosh at James.Mackintosh@wsj.com