NEW YORK, March 1 (Reuters) – Investors, reeling from recent volatility in global financial markets, have their eyes on another potential concern: a recovering dollar.
The dollar is up almost 4% from its recent lows and is near a seven-week high against a basket of other major currencies, buoyed by bets that the Federal Reserve will have to hike rates more than many investors had previously forecast cool down inflation.
The US currency remains about 8% below the 20-year high it hit last year. But its rebound, coupled with a rise in government bond yields, has already clouded the prospects for a number of trades that were thriving as the dollar fell in the second half of 2022.
The MSCI Emerging Markets Equity Index (.MSCIEF) is down 8% from its January highs, while the MSCI Emerging Markets Currency Index (.MIEM00000CUS) is down 3% from its early February high.
A rally in European equities has also stalled, with the Stoxx Europe 600 Index (.STOXX) remaining little flat over the past three weeks after gaining around 20% since late September. Gold, meanwhile, is trading flat year-to-date after shedding 7% gains.
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“A stronger dollar poses a problem for risky assets,” said Lauren Goodwin, economist and portfolio strategist at New York Life Investments.
The dollar’s recent rebound has weighed on various risky assets
Because of the dollar’s central role in the global financial system, its fluctuations have far-reaching effects.
A stronger dollar tends to tighten global financial conditions while reducing risk appetite and weakening global trade, the Bank for International Settlements said in a November report. Also, countries that have borrowed US currency are finding it more difficult to service their debt, a problem that emerging markets often feel acutely.
“Foreign currency tailwinds from a more dovish Fed are generally off the table,” said Eric Leve, chief investment officer at wealth and investment management firm Bailard.
A stronger dollar also makes crude oil, gold and other dollar-denominated commodities more expensive for foreign buyers. Part of Brent crude’s 2% year-to-date decline can be attributed to the dollar’s recovery, analysts at UBS Global Wealth Management wrote in late February. They expect China’s reopening and Russian supply disruptions to override the US currency’s influence and boost oil later in the year.
For the US, the strength of the dollar is making exports less competitive while also weighing on multinationals’ bottom lines by making it more expensive for them to convert foreign profits into their own currency.
Analysts at Morgan Stanley, led by chief US equity strategist Michael Wilson, wrote on Monday that the dollar’s performance could be a key factor in near-term US stock price action, citing the currency’s relationship to global liquidity conditions . The S&P 500 index is down nearly 5% from its recent highs and is holding on to a 3.6% year-to-date gain.
“If interest rates and the US dollar continue to rise, we believe these key support levels for stocks will quickly give way as the bear (market) returns with more strength,” they wrote.
Whether the dollar continues its recovery will depend in part on how much more the Fed needs to hike interest rates. Some insight into the mindset of policymakers and the strength of the economy could come next week when Fed Chair Jerome Powell delivers his semi-annual monetary policy testimony before the Senate Banking Committee and February US jobs data.
Colin Graham, head of multi-asset solutions at wealth manager Robeco, thinks the dollar is unlikely to rally further and said he would likely bet against the US currency if the dollar index rose to 106 from its current level of 104.
A move to 114, September’s highs, would prompt it to abandon its optimistic view on emerging markets, he said.
Emily Leveille, portfolio manager at Thornburg Investment Management, is also skeptical that the dollar’s rally will continue and sees any weakness in emerging markets as a buying opportunity.
“The currency weakness in emerging markets can be a good time to jump in and build positions in quality companies,” Leveille said.
By contrast, analysts at Capital Economics believe an expected slowdown in global growth and falling risk appetite will drive investors to flock to the dollar, a popular target in uncertain times, and propel the currency back to its highs later this year.
“Against this weaker global backdrop, we expect risk sentiment to deteriorate and ‘safe haven’ demand to propel the dollar higher over the next few quarters,” they wrote.
Reporting by Saqib Iqbal Ahmed; Edited by Ira Iosebashvili and Chris Reese
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