Currency volatility: Will US dollar strength continue?

The U.S. economy has proven to be remarkably resilient, as underscored by strong inflation and labor market data. Consequently, the prospect of less easing by the Federal Reserve (Fed) this year has taken the dollar to new highs — and should underpin its strength going forward.

“Strength in U.S. activity has been a mainstay of our long-dollar bias, and the persistence of U.S. exceptionalism is a major FX theme. But this has always been in the context of high market conviction that the Fed would invariably begin its easing cycle this year,” said Meera Chandan, Global FX Strategist at J.P. Morgan. “This is now being challenged, and the corresponding de-pricing of Fed cuts has taken the dollar to new year-to-date highs. Put simply, the macro market narrative has shifted from ‘when’ to ‘whether’ the Fed will ease this year, and has taken the dollar higher commensurately.”

However, the ongoing improvement in global growth could temper the performance of the greenback, considering the currency tends to appreciate during times of risk and vice versa. J.P. Morgan Research has raised the odds of a “high-for-long” soft landing to 55%, while Purchasing Managers’ Index (PMI) data continue to signal improving breadth and inclusiveness in the global economy.

“There have been several meaningful developments on this front of late, weighing on the dollar given its anti-cyclical properties. This may impede what otherwise looks like a potentially strong U.S.-led dollar environment, though we question whether it can fully offset ongoing U.S. exceptionalism,” Chandan added.

In addition, commodities are once again top of mind for the FX space as the complex has risen almost 7% off February lows. Furthermore, Russia’s decision to cut oil production could push Brent prices to $100/bbl in the coming months, which could benefit the dollar.

This is in part due to the dollar’s positive correlation with oil. Since late 2022, the dollar has tended to move in tandem with oil, especially during supply-driven episodes in the energy markets. Such episodes fuel inflation while also pressuring growth, thus supporting the dollar. “The potential move to $100/bbl would therefore be dollar-positive through the interplay of the dollar’s anti-cyclicality, higher headline inflation and higher yields,” Chandan said.

The greenback’s fading sensitivity to commodity prices also reflects structural changes in the U.S.’s balance of payments that have taken place over the last two decades. The U.S. now produces around 12 million barrels per day (mbd) of crude and has drastically reduced the amount of oil it imports, which means that its international net energy needs are now flat and its trade deficit no longer mirrors shifts in energy imports. As such, swings in energy prices no longer affect the U.S.’s balance of payments the way they once did, to the dollar’s benefit.

Overall, the dollar looks well-placed to withstand a further rise in oil prices. “We also continue to place strong emphasis on yields and the implications of higher-for-longer, and remain constructive on the USD,” Chandan said.