Foreign Exchange

Global Headwinds Drive the Dollar’s Decline

As the yen and euro continue to strengthen, the dollar’s historic run appears to be drawing to an end—get the latest insight into how global headwinds are influencing currency markets.
J.P. Morgan Global FX Strategy & Global EM Research
April 25, 2016

Executive Summary

The Dollar's Rise Halts

The US dollar had an exceptionally strong start to the year, but a number of global headwinds have since combined to push the currency down 3 percent from January’s peak. For America’s most important trading partners, however, the dollar’s “peak” will likely look more like a plateau. Tighter monetary policy and steady economic growth in the US should support a relatively strong dollar for the foreseeable future: Against 22 of the world's 32 largest currencies, the dollar is expected to hold steady or decline only slightly for the remainder of 2016.

The factors that drove the dollar’s rise this winter—including falling commodities prices and fears of a global economic slowdown spurred by weakness in emerging markets, as well as massive monetary easing programs in Europe and Japan that were implemented just as the Federal Reserve prepared to hike interest rates at home—have largely retreated. For a few months, America’s economic fortunes diverged from the world’s, and the dollar made steady gains.

While these trends have not fully reversed, the gradual stabilization of the global economy is pushing currencies back toward their fair market value. Consider:

Domestically, weak inflation allowed the Federal Reserve to adopt a dovish stance toward further interest rate hikes, curtailing the dollar’s rise. The short-term outlook for American monetary policy remains uncertain, but most scenarios favor a slow pace for interest normalization. For example, despite strong job growth, the labor market has yet to tighten. Millions of discouraged workers have returned to the workforce, and yet many analysts believe there's still considerable slack in the labor market. In the face of lackluster GDP growth and weak inflationary pressure, the Fed seems unlikely to act aggressively on interest rates in the near future. However, America is still on a tightening trajectory, and the possible return of inflation later this year could result in a rate hike and may push the dollar to new highs against the euro and yen. 

The Bank of Japan Runs Out of Options

The yen has already gained 10 percent against the dollar in 2016, entirely erasing the losses that the Bank of Japan (BoJ) spurred with its second round of quantitative easing. Despite the adoption of negative interest rates and an aggressive asset purchasing program, the BoJ has proven unable to stop the yen’s rally, which is largely driven by a growing current account surplus. The yen’s strength is pushing up the price of Japanese goods in overseas markets, creating challenges for the nation’s exporters. The BoJ’s Tankan survey, a quarterly poll of business confidence, shows that Japan’s large manufacturers hoped the yen would fall to ¥117.46 against the US dollar in 2016; however, it currently sits at ¥107.

Despite domestic political pressure to contain the yen’s rise, the BoJ has limited options. The yen is still trading considerably below its fair market value, and expansionary monetary policies haven't had much influence on currency movements.

Is the Euro Policy-Proof?

The European Central Bank (ECB) is also finding the currency market increasingly insensitive to its unconventional easing efforts. The ECB has instituted negative interest rates, spurring record outflows from European bond markets; however, exchange rates have been far more responsive to conventional policy moves from the Federal Reserve. It appears that the vast majority of capital outflows from Europe are currency-hedged, leaving no lasting impact on euro values.

Although the current round of quantitative easing has had little influence on exchange rates, the asset purchasing program’s tapering in 2017 may signal the beginning of normalization for eurozone policies.

China Finds Its Footing

Last summer, China’s failure to reach its 7 percent growth target sparked fears of a slowdown throughout the developing world. August's subsequent devaluation of the renminbi further spooked markets, sparking a decline in commodities prices based on expectations of falling Chinese demand.

In past months, however, China’s economic picture has brightened significantly. While the current projection of 6.7 percent GDP growth in 2016 is a far cry from the blistering pace of expansion in past years, it's a sign that the downside risks to the Chinese economy are likely fading. China’s stabilization has helped pull oil and metal prices out of the basement, benefiting the currencies of commodity-exporting nations worldwide. With the possible return of Chinese growth, the chance that the renminbi will lose further value may be reduced. This should, in turn, curtail capital outflows from the country and may limit the renminbi’s fall against the dollar.

Source: J.P. Morgan Global FX Strategy & Global EM Research, Key Currency Views, published April 8, 2016.

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