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High inflation and dollar strength: how are they linked?

By:
on May 16, 2022
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  • The Dollar Index (DXY) strengthened to above 105 and registered a 20-year high.
  • Geopolitical developments and health lockdowns will likely keep inflation sticky.
  • Within a hawkish environment, investor capital gravitates towards the dollar.

Financial markets sold off in a massive rout last week, after the publication of elevated US consumer inflation at 8.3% for the month of April. 

Amid the chaos,the US Senate handed the global monetary reins back to Federal Reserve Chairman Jerome Powell, placing him in the unenviable position of navigating stagflationary currents. 

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Plagued by widespread and ever-mutating viruses for the previous two years, seemingly unlimited stimulus, rock bottom interest rates and the crumbling of well-oiled supply chains, the world economy has been turned on its head.

During lockdowns, authorities rolled out targeted fiscal policies, UBI-style programs and payroll protections in a bid to preserve the common man’s purchasing power. 

Summoning the proverbial hawk, Powell admitted that perhaps interest rates should have been raised earlier, while in a bid to restore price stability, a soft landing is increasingly doubtful.

Claims that consumer prices have peaked may be premature. Even more crucial than the level may be the persistence of inflationary pressures.

Sticky inflation and rate hikes

The world is in the midst of a geopolitical chess match, replete with sanctions, military actions, and turbulent energy supplies. The FAO’s Food Price Index averaged 158.5, moderating from its all time high of 159.3 recorded during the previous month. Even fertilizer prices are on a rampage, impacting the most essential items. Tensions rose as Russia came to verbal blows with Sweden and Finland over their intention to join NATO.

Recent estimates suggest that due to country-wide lockdowns, it takes approximately 100 days for Chinese goods to reach their intended destination in developed markets. Cautious optimism in China has all but evaporated with the likelihood of severe health restrictions being reinstated. 

These factors naturally contributed to concerning data last week. The leading indicator of US consumer prices, the producer price index, was 11% higher from a year ago, skyrocketing from a contraction of -1.5% in April 2021.

In such an environment, inflation is unlikely to recede rapidly necessitating front-loading of rate hikes.

However, the credibility of the Federal Reserve as the world’s inflation fighter remains questionable. History suggests that imploding equities and burgeoning debt payments amid falling growth may force a policy re-think. With US consumer debt seeing the fastest quarterly increase since 2007, hiking rates may trigger defaults and a deep recession. 

Although Chairman Powell has been emphatic that rate hikes will not waiver, new realities may emerge to challenge the Fed’s resolve.

The unchallenged power of the dollar

Even though every asset class has lost considerable value this year and investors are nervous, markets have found refuge in the dollar. As the world’s reserve currency, the dollar is trusted more than any other financial instrument to safeguard an investor’s holding during  market turmoil.

In fact, during market uncertainty this year, the dollar has gained value and is even trading at historic highs. The DXY is an index of the dollar’s strength compared to other major currencies.

The US economy is considered the safest in the world, where investors would take on minimal risk.

US government bonds are said to provide the risk-free rate, that is, they are that financial instrument that can provide a return at the lowest possible risk (or considered to have no risk at all).

Theoretically, investors invest outside the US when they are looking to earn a higher return. At the same time, they accept that other markets are riskier.

However, when market sentiment is more hawkish, that is to say, expecting the Fed to hike rates, investors prefer to leave riskier markets and place their investments in the US with the aim of earning a higher return  at the lowest possible risk.

Thus, portfolio flows gravitate towards the US.

This effect can be seen in the graph below. When the likelihood of a higher rate hike grows as per market surveys, the DXY or the dollar strengthens.

Source: Federal Reserve Bank of Atlanta; Marketwatch

At the beginning of this year, the DXY stood at 96.21. 

The rise in the dollar during the year is also a response to growing market uncertainties from unprecedented lockdowns, the Ukraine-Russia war, and supply chain disruptions.

During the end of February, the DXY saw a sharp uptick, with the invasion of Ukraine. Each of these factors results in a more hawkish view, that is the expectation that inflation will persist and so rates should be raised.

Today, as the Fed is more hawkish than ever before, the DXY has galloped to 20 year highs of over 105 during the last week.

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