Dollar’s relentless rise ‘sending shivers through global markets’

“The yen remains at the mercy of the US Federal Reserve,” Skylar Koning, a senior macro strategist at TS Lombard, said. “Dollar strength is a destabilizing force globally.”

The greenback has appreciated 8 per cent against Japan’s yen this year and is 4 per cent stronger on a trade-weighted measure against a basket of major currencies.

Known as the dollar index, the trade-weighted dollar climbed to a 2024 high at the start of May and is approaching levels not seen since the mid-1980s, when aggressive US interest rate rises under the Fed chairman at the time, Paul Volcker, attracted a flood of overseas capital into the dollar. The ascent was so punishing for the world economy that it led to the signing of the Plaza Accord in 1985, where the US, UK, France and Germany agreed a deal to end the reign of the strong dollar.

The dollar’s recent surge has echoes of the pre-Plaza Accord era when John Connally, US treasury secretary under President Nixon, famously told his G10 counterparts that the “dollar may be our currency, but it’s your problem”.

Problems are now mounting in the rest of the world. The Chinese authorities have been trying to support the renminbi to prevent a disorderly and abrupt devaluation as part of the Communist Party’s “strong renminbi” policy. Indonesia’s central bank surprised markets last month by raising interest rates as part of a pre-emptive move to support its sliding currency.

Central banks in Mexico and Brazil, which have been easing monetary policy this year, are likely to pause on further rate cuts for fear of pushing down their exchange rates too far against the dollar. Even the European Central Bank, which has all but confirmed it will cut borrowing costs this June, is worried about the euro falling to parity with the dollar, a move that could stoke a fresh bout of inflation in the fragile eurozone economy.

“The dollar is once again sending shivers through global markets as its rise generates fearful headlines about risks to economies large and small,” Neil Shearing, group chief economist at Capital Economics, said. “Central bankers are clearly getting nervous.”

• Nikkei back on top as Japan harks back to the Eighties

The dollar’s strength has been driven by a constellation of factors that have led investors rushing into the greenback this year. The most important has been the rapid repricing of prospective US interest cuts, which have been slashed from a projected eight rate cuts at the start of the year to only one 0.25 percentage point reduction in December, according to market data.

Hopes of major monetary loosening have faded as the US economy, the fastest growing in the G7, has recorded three months of higher-than-expected inflation. Tight monetary policy in the world’s largest economy has prophesied the “carry trade”, where investors borrow in low rate environments such as Japan, to invest in higher-return currencies such as the dollar.

Even bad US economic data cannot dent the dollar, which has been given a further boost by “safe haven” flows. When investors are jittery about the escalating conflict in the Middle East, they head for the safety of the dollar. The result has been a seven-month high for the greenback against developed market and emerging market currencies.

The dollar’s might is now threatening to derail the steady disinflation experienced in many economies this year, as a weaker exchange rate pushes up the price of imports, such as global oil and gas, which are priced in dollars. Companies and governments who have also borrowed in dollar-denominated debt face punishing debt-servicing costs when their local currencies slide against the greenback.

• Federal Reserve says rates are likely to stay higher for longer

The dollar’s trajectory and the fallout for the world economy will depend on the actions of the Fed, which kept its borrowing costs on hold again last week and warned that inflation was not coming down as fast as it had expected.

According to one study, a one percentage point monetary policy tightening shock in the US economy reduces industrial production in advanced economies by 1.5 per cent on average. This tightening is the equivalent of having only two interest rate cuts this year compared with the six forecast in January, Gilles Moëc, group chief economist at Axa, an insurer, noted.

But Shearing at Capital Economics said the strength of the dollar had not been “large or fast enough to cause broader financial dislocation” just yet. “A string of currency crises looks unlikely,” he added.

The strong dollar is good for American holidaymakers and is disinflationary for the US economy. But not all parts of the country benefit from a surging currency. Donald Trump has hinted that he wants to devalue the dollar to support American manufacturers, who are crimped by a strong exchange rate that makes their exports more expensive to the rest of the world.

It has raised fears that the Republican presidential nominee will put pressure on the Fed to cut rates fast if he wins office in November, and fueled growing speculation that Trump wants to sack Jerome Powell, the central bank’s chairman.

In reality, it will be difficult for Trump or any president to engineer a big devaluation of the dollar unless the US agrees to a repeat of the Plaza Accord for the 21st century. The Japanese authorities are also learning how hard it is to push back the tide of a surging dollar, as its interventions have struggled to meaningfully prop up the yen.

“Foreign exchange intervention is most successful when it is co-ordinated with other central banks or foreign monetary authorities, and catches the market by surprise,” Jenny Grimberg, at Goldman Sachs, said. “None of which was the case for the recently suspected [Japanese] intervention.”