The worrying fall in the Dollar

The Dollar fall far exceeds what fundamental drivers can explain

The US and China have announced a de-escalation of the trade war. Tariffs on both sides are being reduced from clearly unsustainable levels to somewhat less onerous levels. The Dollar is rallying in response and has risen about 1.5 percent so far today.

The fact that the Dollar is rallying on tariff reductions - and that it fell on previous tariff hikes - is very unusual and worrying. US tariffs are a negative shock on other countries, in response to which the Dollar should rise as a market offset. The opposite has happened. In this post, I look at the recent behavior of the Dollar, including its recovery today, and conclude that recent declines are highly unnerving.

There is no sure-fire way to explain the behavior of exchange rates. They often fluctuate wildly, so it’s important to be realistic about what can and cannot be explained. That said, we know that strong growth tends to strengthen currencies, because markets expect this growth to feed into central bank hikes. Markets flock to currencies with high interest rates. Similarly, rising inflation is often seen as currency-positive, because - again - it can spark a central bank hiking cycle. This intuition is captured in interest rate differentials - the difference between a country’s interest rate and those in its trading partners - and those rate differentials typically closely track exchange rates.

The chart shows the trade-weighted Dollar (black line) against its G10 peers, i.e. against the currencies of other advanced economies like the Euro and the British Pound. It also shows the corresponding trade-weighted interest rate differential (blue line), where I am using the same trade weights in the Dollar index to calculate the rate differential. I am looking at the 2y2y forward interest differential, which you get by splitting out the second half of 4-year interest rates. Markets like this tenor because it gives a more forward-looking perspective on where interest rates are headed.

The Dollar closely tracked this interest differential, both on the way up between the election on November 5 and inauguration on January 20 and then subsequently on the way down after January 20. However, the Dollar decoupled after the reciprocal tariff announcement on April 2 and - especially - after the announcement of the 90-day pause on reciprocal tariffs on April 9. Even with today’s rally, the Dollar has yet to close the gap with the 2y2y forward rate differential.

The sharp fall in the Dollar after April 9 is significant. One week after announcing reciprocal tariffs, the US suspended them. In effect, the US looked like it was negotiating against itself and the sharp fall in the Dollar around that time looks like markets punished this policy volatility. All this is highly unusual. As I note above, the imposition of tariffs on the rest of the world should have seen the Dollar rise. No doubt, it will take a long time to undo Dollar reserve currency status, but this is the first time I’ve begun to worry that US reserve currency status is wobbling.