Dollar strength drives commodity sell-off
By Delphine Strauss and Michael Mackenzie
Fears over global growth and uncertainty over US monetary policy left a rally in the dollar fizzling throughout October. Now, central banks have reignited it - potentially with far-reaching implications for commodity prices and global investment flows.
Japan's aggressive expansion of its stimulus programme, coming just two days after the US Federal Reserve announced the end of quantitative easing and set the clock ticking for the first rise in interest rates, shocked currency markets.
The divergence in policy sent the yen crashing to its lowest level against the greenback since the start of 2008, and there is scope for it to weaken further.
Alan Ruskin, a strategist at Deutsche Bank, says Japanese investors and companies "are likely to chase the market", adding that the yen's status as the best currency to fund carry trades is now assured. Moreover, Japan's national pension fund will reinforce the trend, as it shifts a higher proportion of its holdings into foreign assets at a time when the strong dollar increases the appeal of US bonds and equities.
A trade-weighted measure of the dollar has also reached a four-year high, reflecting speculation that other central banks will feel impelled to follow the Bank of Japan's lead. Asian trade rivals such as South Korea and Taiwan may now feel the need for a weaker currency to remain competitive. The European Central Bank - already under pressure to launch large-scale purchases of government bonds - could also feel the heat if a weak yen worsens deflationary pressure on the eurozone.
"The market will soon question which central bank will be next to follow the Bank of Japan's steps and ease policy," says Paul Mackel, strategist at HSBC. "What is clear to us is that there is only one net beneficiary - the US dollar."
But while the case for a stronger dollar appears clear-cut to many currency traders, the extent of its rise, and the implications for other asset classes, may be harder to predict.
Once the dollar starts to move, the trend can be both large and persistent: it fell by more than 25 per cent in a period of weakness that lasted from 2002 to the start of the financial crisis. Since 2011, it has recovered less than half those losses - leading many analysts to argue that the world's reserve currency is set for an extended bull run.
Past periods of dollar strength have been associated with outperformance of US equities, and with tumbling commodity prices - for precious metals in particular but also for base metals, energy and agricultural commodities. In the 1980s and 1990s, a strong dollar also fuelled crises in emerging markets, as currency pegs snapped and the burden of dollar-denominated debts grew.
This seems consistent with recent trends in markets. Commodity prices have slumped since the summer. The dollar's surge last week was accompanied by an all-time high in the S&P 500 stocks index and a fall in the gold price to its lowest level since 2010. It also added to pressures on emerging markets such as Brazil and Russia, which raised interest rates in response to political turbulence and weaker commodity prices.
However, analysts at Barclays warn against assuming that a dollar trend will follow any "typical" pattern. The path of China's economy is now likely to be at least as influential for commodities and resource-related stocks as the dollar, they argue.
And the old link between a strong dollar and S&P outperformance may no longer hold. In recent years Fed stimulus kept the dollar weak while boosting US equities. So the prospect of higher US interest rates may now boost the dollar but weigh on equities - especially as multinationals must also contend with slowing global growth.
Moreover, weak commodity prices are exacerbating the low inflation that is affecting almost all developed economies - including the US.
Analysts believe the US will be more tolerant of a strong exchange rate than other major economies, because its economy relies far more on consumption - which will receive a boost - than it does on exports. But the Fed could push back against a sustained bull run. Policy makers have flagged up the risk of a rising dollar damping already low inflation; further appreciation could therefore limit the pace of future rate hikes.
"While global growth trends are diverging, the global inflation challenge is shared," says Lena Komileva, of the consultancy G+ Economics. "With inflation still the missing part of the global recovery, the so-called 'currency wars' have not gone away."
(c) 2014 The Financial Times Limited