Home/ Markets / Stock Markets/  An epic dollar rally goes into reverse—and investors expect further declines

The U.S. dollar’s rally in 2022 gave the world a reminder of the currency’s ability to inflict pain on the global economy. Investors are optimistic that the dollar’s strength has now run its course.

As of Dec. 28, the dollar has risen 8.9% this year as measured by the WSJ Dollar Index, which tracks its value against 16 other currencies. That would mark its biggest yearly rise since 2014. The index peaked in late September at the highest level in data going back to 2001.

But the dollar is ending the year on the defensive, having given back roughly half of its gains since that high-water mark, as investors bet that U.S. inflation is slowing.

Most investors were caught off guard by the greenback’s strength this year. The currency had already risen in 2021 on expectations that the Federal Reserve would start raising rates this year to tame what Wall Street believed was a temporary increase in inflation. Some investors thought the dollar was overvalued and poised for declines.

Few were expecting inflation to stay so stubbornly high, or for the Fed to raise rates by more than 4 percentage points in the span of nine months. Rising rates boost the dollar by attracting investors from around the globe into U.S. assets such as Treasury bonds. Russia’s invasion of Ukraine turbocharged the dollar as investors fled to assets seen as safe and a surge in energy prices compounded inflationary pressures.

“Without Russia invading Ukraine, [a weak dollar] would have been the correct call" for 2022, said Derek Halpenny, head of research for global markets in the European region at Japan’s MUFG Bank. “That was the massive change, because that created this second global inflation shock that forced the Fed to go the way it did."

The effects of the dollar’s rise have been global, helping to push foreign currencies down to historically low levels. The euro broke through parity with the dollar in July, and the British pound in September touched its lowest point in over 200 years of trading against the dollar, while the Japanese yen fell to its weakest point since 1990.

“The dollar can be like a vortex: as it starts to build power, the weaker things get taken up first," said Andrew Keirle, a global fixed-income portfolio manager at T. Rowe Price. “When that centrifugal force grows and grows and grows, eventually even the good assets will start to move."

Swings in the dollar tend to be felt worldwide because of its role as the primary currency for trade and finance. Its rise has made commodities such as wheat and American goods more expensive for buyers outside of the U.S. That added to inflation in other countries and weighed on the businesses of U.S. firms who rely on business abroad.

In some poorer nations, the currency’s rise has been devastating. Sri Lanka nearly ran out of dollars this year as it burned through its pile of currency reserves, already depleted by the pandemic, to pay for imports of basics such as fuel and food.

“While major emerging markets didn’t experience anything near a crisis, there is a quieter crisis that has hit many parts of the world, especially a lot of low-income economies that don’t tend to get a lot of attention," said Eswar Prasad, a trade policy professor at Cornell University. “For many of them the surge in food and commodity prices, both of which tend to be significantly denominated in U.S. dollars, was an enormous hit."

A stronger dollar has also fueled debt crises in some emerging markets by making their liabilities denominated in the U.S. currency more expensive to repay. The Western African nation of Ghana became the latest country to start the process of restructuring this month after a vicious selloff in its currency drove up the cost of servicing its foreign-currency debts.

Many investors are hopeful that the dollar has peaked. Stephen Jen, chief executive of the hedge fund Eurizon SLJ Capital, expects the dollar to fall 10% to 15% next year against major peers as U.S. inflation slows and investors refocus on the “serious structural flaws" of the U.S. economy, such as its high debt levels.

Steve Englander of Standard Chartered also thinks the dollar will weaken as the growth outlook for other economies improves. China’s reopening should fuel economies overseas, while he expects concerns over Europe’s energy security to fade throughout the year.

“In the course of the first quarter, those question marks are going to be removed and that is going to end up being positive," said Mr. Englander, who is head of foreign-exchange research for the G-10, or Group of Ten nations, at the bank. “But there is going to be a lot of three-steps-forward, two-steps-back for the dollar until the picture becomes clearer," he said.

Analysts at JPMorgan Chase & Co. are more cautious about calling for an end of dollar strength and forecast that the dollar will rise another 5% against major trading partners next year. They believe demand for dollars will remain resilient as central banks continue to tighten policy and recession risks rise.

Prospects for low-income economies that have been hit hardest by the dollar’s strength and rise in borrowing costs remain bleak. Many have burned through foreign-exchange buffers this year and remain shut out of global borrowing markets.

“If the Fed were to stop raising rates and the dollar would continue its gradual decline, that would take some pressure off low-income economies," said Mr. Prasad, of Cornell. “But many of them are facing such difficult circumstances in terms of the financing of imports, in terms of losing access to external financing, it’s going to be a very rough year for them no matter what."

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