Surging Risk Assets Across the Globe Amidst the Tumbling US Dollar

Introduction

The weakening US dollar positively impacts risk assets worldwide, thanks to the cooling of US inflation. The dollar has declined by nearly 13% against a basket of currencies since reaching a two-decade high last year, and it currently stands at its lowest level in 15 months. The recent softer-than-expected inflation data reported by the US has further accelerated the dollar's decline, indicating that the Federal Reserve is approaching the end of its interest rate-hiking cycle. As the dollar plays a crucial role in the global financial system, numerous assets stand to benefit from its continued depreciation.

Boon for US Companies and Technology Sector

The weakening dollar can prove advantageous for US companies, as it enhances the competitiveness of their exports abroad and reduces the cost for multinationals to convert foreign profits into dollars. In fact, an analysis conducted by Bespoke Investment Group on Russell 1000 companies revealed that the US technology sector, which includes several leading growth companies, generates slightly over 50% of its revenues overseas. This dependency on foreign markets positions the sector to gain from the weakening dollar.

Raw Materials Become More Affordable

With the decline of the dollar, raw materials priced in dollars become more affordable for foreign buyers. Consequently, the S&P/Goldman Sachs Commodity Index (.SPGSCI) has experienced a 4.6% increase this month, making it the most successful month since October. This trend benefits various sectors and industries relying on raw materials, such as manufacturing and construction.

Emerging Markets and Debt Denominated in Dollars

Emerging markets also reap the rewards of a weakening US currency, as it makes servicing debt denominated in dollars easier for them. The MSCI International Emerging Market Currency Index (.MIEM00000CUS) has already seen a 2.4% increase this year, indicating the positive impact on emerging economies. By reducing the burden of dollar-denominated debt, these markets can allocate more resources toward growth and development.

Weaker Dollar Boosts Global Assets

According to Alvise Marino, a foreign exchange strategist at Credit Suisse, the weaker dollar, driven by lower inflation, acts as a stimulus for global markets, particularly for assets located outside the US. This decline in the dollar's value coincides with a decrease in US Treasury yields, diminishing the dollar's attractiveness while simultaneously strengthening other currencies, including the Japanese yen and the Mexican peso. As a result, technical levels across foreign exchange markets are being breached, and risk-sensitive currencies are experiencing a significant surge worldwide, as stated by Karl Schamotta, chief market strategist at Corpay.

Profits from Foreign Exchange Strategies

If the dollar continues to fall, it could generate profits for foreign exchange strategies like the dollar-funded carry trade. This strategy involves selling dollars to purchase a higher-yielding currency, enabling investors to profit from the interest rate differential. The dollar's decline has already proven profitable this year for investors engaged in such strategies. For instance, data from Corpay reveals that an investor selling dollars and buying the Colombian peso would have gained a return of 25% year-to-date, while the Polish zloty yielded 13%.

A Relief for Some Countries

The weakening dollar provides relief to countries that are under pressure to support their depreciating currencies. Japan is a notable example, as the dollar has recently fallen by 3% against the yen, marking its largest weekly drop against the Japanese currency since January. The depreciation of the yen had been problematic for Japan's import-reliant economy, leading to speculation that Japan might intervene in the markets to support its currency. Similar concerns were raised regarding the Swedish krona, but this week the dollar has depreciated by nearly 6% against the krona, resulting in its most substantial weekly decline since November.

Potential Risks and the Outlook for the Dollar

While being bearish on the dollar presents opportunities, it also carries risks. One such risk is the possibility of a rebound in US inflation, which could trigger expectations of a more hawkish stance by the Federal Reserve and reverse many of the trades against the dollar that have flourished this year. Despite the cooling of inflation, the US economy has demonstrated resilience compared to other countries, and it is unlikely that the Federal Reserve will cut interest rates anytime soon. This could potentially limit the near-term downside for the dollar. However, Helen Given, an FX trader at Monex USA, believes that the Federal Reserve will conclude its rate-hiking cycle before most other central banks, thereby diminishing the long-term momentum of the dollar. Looking ahead, it is likely that the dollar will continue to weaken even further in the next six months.

Footnote

The tumbling US dollar has emerged as a boon for global risk assets. Its depreciation against a basket of currencies, coupled with softer-than-expected inflation data and the potential end of the Federal Reserve's interest rate-hiking cycle, has triggered a surge in various assets.

Notably, the weaker dollar benefits US companies through enhanced export competitiveness and favorable currency conversion rates for multinational corporations. The technology sector, in particular, has witnessed substantial revenue generation from overseas sources.

Moreover, the decline in the dollar has made raw materials more affordable for foreign buyers, leading to a significant increase in the S&P/Goldman Sachs Commodity Index. Emerging markets have also experienced positive effects, as the easier serviceability of dollar-denominated debt has boosted the MSCI International Emerging Market Currency Index.

Image Source from Reuters

Market experts anticipate further weakening of the dollar, potentially leading to increased profits for foreign exchange strategies like the dollar-funded carry trade. However, the bearish outlook on the dollar is not without risks, such as a possible rebound in US inflation that could reverse the anti-dollar trades.

In terms of monetary policy, the dollar's decline has brought relief to certain countries, reducing the need for immediate support to their depreciating currencies. Japan and Sweden, in particular, have experienced significant movements against the dollar, raising concerns about possible interventions and unwinding of bearish positions.

Looking ahead, the long-term momentum of the dollar is expected to weaken, with the Federal Reserve anticipated to conclude its rate-hiking cycle ahead of other central banks. However, the US economy's resilience and the potential limits on the dollar's downside pose additional factors to consider.

In the meantime, the tumbling US dollar has ushered in a new era of opportunities and challenges for global markets. As investors navigate the changing landscape, the impact of the dollar's depreciation on risk assets and monetary policies will continue to shape the future dynamics of the financial world.