Where is the Limit of the Dollar Rising?

On Thursday, July 14, the U.S. dollar rose again, and the U.S. dollar index rose by 1%.

After February, the U.S. dollar index rose sharply, surpassing March 2020 levels at the start of the pandemic and hitting a 20-year high.

The question for the market now is whether the dollar can continue to be strong, or has it reached the end of the battle?

The market generally believes that the dollar can continue to rise; whether it is a hawkish Federal Reserve, or the global recession and other factors, those are the factors driving the dollar higher.

"The dollar is too strong; don't resist."

According to George Boubouras, head of research at Melbourne-based hedge fund K2 Asset Management: Don't resist, now is not the right time to fight against a stronger dollar. Recession risk in developed markets hasn't bottomed out-it's too hard to short the dollar in the short term.

The Bank of America expects the dollar to continue to strengthen through the end of the year as the Federal Reserve raises interest rates to combat the wildest inflation in decades. Citigroup believes that global demand for the greenback and its reserve currency status remains unrivaled, while Goldman Sachs sees the greenback rising sharply against emerging currencies such as the Brazilian real and the South African rand.

Regarding the US dollar index, the earliest turning point we can imagine is the fourth quarter of this year, when the Fed's policy may not be so aggressive and there will be some improvement in the major emerging Asian economies. Until these things happen, a stronger dollar remains the path of least resistance.

Investors' dollar positioning remains firmly bullish, but far from extreme, according to data compiled by the U.S. Commodity Futures and Trading Commission. Current bullish bets are around $16 billion, compared to nearly $36 billion in mid-2019.

According to Wai Ho Leong, a strategist at Singapore-based hedge fund Modular Asset Management, "We think the current phase of USD strength will continue for some time-at least until the Fed signals that aggressive policy tightening is no longer needed." We may be approaching that tipping point, but it's hard to say when that transition will occur.

An inflection point is coming? Still, not everyone thinks the dollar's strength will continue.

Thomas J Hayes of hedge fund Great Hill Capital LLC estimates the dollar will fall by the end of the year and the biggest catalyst will be a change in policy by the Bank of Japan. UBS also believes that the inflection point of the dollar is coming or has come.

The team of UBS analysts James Malcolm said: In terms of global inflation and expectations of monetary tightening by central banks, we believe that the market is now experiencing an inflection point, and now is a good time to be short on the dollar and long on the yen and euro.

UBS believes that the dollar is supported by: aggressive interest rate hikes by the Federal Reserve, higher global energy prices, and global recession risks will gradually fade in the future, and the fundamentals are likely to start moving in the direction of mean reversion soon.

As the Fed aggressively hikes rates, higher real rates will also eventually tighten fiscal conditions and add upward headwinds to the U.S. economy, weighing on the dollar.

Meanwhile, Europe is pushing for energy contingency plans. In addition, UBS believes that if Russia cuts off the Nord Stream 1 pipeline completely and permanently, it will lose a key lever to check and balance Europe, which will further trouble the Russian economy. Whether or not Saudi Arabia increases its oil supply, UBS expects global energy prices to fall.

In addition, global long-term inflation measures are weakening as economic activity slows, and federal funds futures have retreated. While interest rate volatility remains high for now, the one-way catch-up with the Fed at the forefront may be over.

Finally, UBS pointed out that the tension in the global manufacturing supply chain has been significantly eased, and it is expected to suppress the US dollar for a long time, while the Fed's pressure indicators reflect the poor performance of the US stock market. UBS believes that this will eventually translates into capital outflows from the U.S., making it difficult to continue funding U.S. record fiscal numbers.

What are the consequences of the continued strength of the dollar?

It is clear that a stronger dollar means a substantial depreciation of non-US currencies.

The yen has fallen to its lowest level in 24 years and the euro has fallen to parity with the dollar, all of which have been hot topics for investors recently.

Currency devaluations in emerging markets could cause bigger social problems. For example, the recent crisis in Sri Lanka was closely related to the sharp depreciation of the country's currency.

Alarmingly, dollar claims (loans and debt securities) in the non-financial sector of emerging markets and developing countries reached a record level of nearly $4 trillion last year after more than a decade of easy monetary policy. This means that currency volatility in developing markets is unlikely to disappear in the foreseeable future.

In developed markets, compared with the Bank of Canada, which resolutely and violently raised interest rates by 100 basis points on Wednesday, the European Central Bank appears to be cowardly and timid.

On the one hand, because inflation data varies widely among countries in the eurozone, the ECB cannot quickly make a decision that satisfies all member states.

In addition, the current domestic tension in Italy, the third largest economy in the EU, also makes the ECB's decision extremely difficult, and many investors are even worried that the ECB will be held hostage by politicians.

In the foreseeable future, if the dollar continues to strengthen, the pressure on non-dollar currencies will continue to rise, which will have an impact on the local economy and even politics.