In 2022, particularly between June and July, the US dollar has gained strength, not only when compared to Latin American emerging economies but also against developed ones, like European. A historic milestone was hit when the euro and the dollar reached parity for the first time in 20 years, with the sterling pound also in decline. So, what forces make other currencies weaker while strengthening the dollar?
Europe feels the impact of war
The latest US negative growth figure, at -0.9%, marks the second consecutive quarter of economic contraction, enhancing the expectations of a global recession. The perception of the European economy, however, has become increasingly pessimistic. Particularly, in connection with the supply of natural gas.
Chart 1: Own elaboration. Data by Bloomberg
Chart 1 shows the impact that the war in Ukraine has had on the euro. The Russian invasion is geographically close and affects the natural gas flow, an essential element for many Eurozone economies. The gas situation especially impacts highly dependent countries, such as Germany. It has led to a euro devaluation of 13.7% throughout the last twelve months, as investors expect this to have negative consequences for the economy of this country, one of the leading forces behind the union.
Even though the UK’s reliance on Russian gas is at 9% -against 39% for the EU- the British pound sterling was dragged down by the regional tensions. The political crisis in the Conservative party adds up to the situation: the mass resignation of ministers, secretaries, trade envoys and party chairmen led to the resignation of PM Boris Johnson on July 7.
But gas is not the only factor in this trend. The European economy shows signs of weakening, as July’s PMI (which measures the performance of manufacturing orders) was 49.8, maintaining a declining tendency and falling below 50 points for the first time since July 2020.
These figures raise concern as inflation keeps growing, reaching a historical high of an annualized 8.9% in July. As a consequence, the European Central Bank has raised its rate by 50 basis points, its first increase in 11 years. Such measure fuels the fear of an impact on consumption, which could, in turn, affect the growth expectations (at 2.6% for 2022 and 1.3% for 2023, according to the European Commission).
Meanwhile, the US Dollar strengthens
Clearly, the US dollar cannot escape the dynamics of the US economy. Both the recent inflation increase and the second quarter’s contraction figure have had an impact on its strength and allowed a slight recovery of the euro. We should note, however, that inflation levels since last December—the highest since 1981- were the first signal for investors on a possible rate hike by the FED in 2022. The possibility became real, and the rate spiked from 0.25 to 2.50% in 5 months, including two aggressive raises of 75 basis points each.
This combination of factors has driven the global dollar’s strength, as it makes investing in the US more attractive. In addition, a higher risk perception by investors led them to sell their positions in other assets and move them to safer investments. Consequently, the demand for dollars increased, and the currency became even stronger. Chart 2 shows the behavior of the DXY index and the Fed funds rate upper limit. The relationship is clear, and if the expectations of a global recession continue to grow, this trend will become more pronounced.
Chart 2. Own elaboration. Data by Bloomberg
As for what can be expected for the remaining of the year, fears are far from being allayed. Prices are not going down in the United States or globally, which portends further rate increases by central banks. The ECB is the latest one to join the party, which may add to the attractiveness of the US to investors and to a dollar that remains strong worldwide.
This report was prepared by Gandini Análisis for Supra Brokers for informational purposes only and should not be construed as investment advice.
