Declining inflation in the United States is pushing down the dollar. Analysts expect a more prominent role for currencies from emerging markets.
There are ‘strong indications’ that the decreasing US inflation figures, resulting in a lower interest rate expectation in the United States, have triggered the start of a cyclical decline of the dollar, say ING’s currency analysts, Frank Turner, and Francesco Pesole, in a note to investors.
The dollar index, which compares the value of the American currency to a basket of six other currencies, reached a low of 99 points this week, a 14 percent decrease compared to September last year.
“The dollar is not falling as rapidly as at the end of last year, but the direction is clear. The US dollar will decline further,” said the analysts.
The US Dollar Index (DXY)
Wim Vandenhoeck, portfolio manager of Invesco’s emerging market strategy, also emphasizes the likelihood of a prolonged downward trend for the dollar due to the expected transition from a period of monetary tightening to easing by the Federal Reserve.
According to Vandenhoeck, an institutional investor will no longer be “forced” to buy US treasury paper or American stocks. Among others, the euro benefits significantly from the expected shift in interest rate differentials.
Currently, the euro is trading around 1.12 US dollars, while investors received only 96 cents for it in September last year. The options market, where the currency pair’s exchange rate is speculated upon, indicates a new range of 1.09-1.16 for the third quarter and 1.08-1.18 for the fourth quarter.
Euro investments are thus attractive from a currency perspective, but most specialists believe that better, risk-adjusted returns can be achieved elsewhere. Mainly investors in currencies from areas with higher real interest rates, such as emerging markets, are benefiting from the expected interest rate cuts in the US.
Local currency
Emerging markets, where central banks raise interest rates earlier and faster, are expected to have reached the end of policy tightening. The higher rates in emerging markets have made many local currencies popular targets for carry strategies in the first half of 2023.
Vandenhoeck: “In the past months, we have seen inflows from institutional investors into the local currency market, and we expect this trend to continue, as there is still less investment in the asset class than average.”
Especially currencies from Latin American economies, with the exception of the Argentine peso, are performing well. The real interest rates are high, growth conditions are favorable, and external balances are improving, explains Simon Harvey, head of FX analysis at Monex Europe.
“The only question for some Latin American currencies is how long the increases will last. Therefore, for example, Monex prefers the Brazilian real over the Mexican peso. The less crowded positioning, the higher base rate of interest on which policy can be eased, and exposure to Chinese stimulus - which is expected to be announced in the coming months - make the real more attractive,” according to Harvey.
Defensive
According to him, investors who want to benefit from a declining dollar within the defensive part of their portfolio should consider holding hedged short-term US government bonds as well as Japanese assets. The latter category may be more interesting without currency hedging to take advantage of a potential appreciation of the Japanese yen during a deterioration of global economic growth or a tightening by the Japanese central bank.
Exposure to the Swiss franc due to the Swiss central bank’s reluctance to let the franc depreciate at the moment is also ‘not a bad move’ for defensive allocations.
Euro
While some analysts expect the dollar to continue to fall in the next three months, Harvey is more cautious. Particularly, a further decline against the euro seems unlikely to him. Slow growth in the eurozone and China, combined with an ECB that is unlikely to raise the deposit rate to four percent, take the edge off the rally, according to him.
On the other hand, the reduced risk of an immediate recession and the unlikelihood of a new energy crisis mean that any potential downward movement of the euro will be limited, Harvey explains. “That’s why I expect that the recent rise of the euro-dollar pair after last week’s soft US inflation report reflects the beginning of a new balance instead of the start of a structural revival for the euro. Option prices support that view.”