After plenty of to-ing and fro-ing about the impact of cutting rates ahead of the Fed, the European Central Bank (ECB) confirmed that, with inflation now effectively at the 2% target, a rate cut should be expected at next week’s monetary policy committee meeting. As this decision reached the consensus, the euro moved lower and fell almost 3% against the dollar since the start of the year. Conversely, the Fed is seemingly backing out on expected rate cuts, with the market now pricing in just 25 basis points over the entirety of the expected easing cycle. At the start of the year, seven rate cuts were priced in for this year alone. While much of this is due to stickier inflation in the U.S., it also relates to ongoing U.S. exceptionalism and few signs that Europe is anywhere near catching up. This suggests that even when the Fed decides to lower rates, we may see some cyclical softening, but structurally, the dollar will likely remain relatively stronger.

For the last two decades, major changes in the value of the dollar were largely the result of risk-on/risk-off moves in financial markets. While the dollar smile theory—which believes the U.S. dollar outperforms other currencies when the U.S. economy is extremely strong or weak—still tends to be roughly appropriate, we believe a “dollar sponge” analogy has been more descriptive. When liquidity is plentiful and growth is strong, the dollar sponge gets squeezed, and that liquidity floods the international capital markets, searching for yield, resulting in a weaker dollar. When growth weakens, the dollar starts to soak up liquidity as investors look for the safety of dollar assets.

This is the third great dollar bull market since President Nixon unshackled it from gold in 1971. Over the years, a common refrain from the anti-Fed crowd has been that the central bank has been steadily devaluing the currency ever since. While a stronger dollar might be helpful for the Fed in its battle against inflation, the risk is that it eventually starts to break things as it ratchets up pressure on the global financial system, which remains very dollar-based.

The dollar, and what’s driving it, is once again having a greater impact on financial markets. As inflation and economic growth rates have started to diverge again between the U.S. and other trading nations, the influence of interest rate differentials is resurfacing. While there’s a strong possibility that the U.S. will end up lowering rates in the upcoming year, U.S. economic growth exceptionalism suggests the dollar will likely remain structurally strong. However, a stronger dollar also puts more pressure on the financial system and increases the risk of something breaking. If this dollar strength is set to continue, investors should again look at areas with a positive or less negative correlation with the currency.

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