By Joseph Adinolfi
2022 is shaping up as a historic year for markets, including the world’s reserve currency.
While the S&P 500 is headed for its worst first half in more than five decades, the dollar appreciated during the first six months of 2022 by the largest margin in history, according to some measures.
The Federal Reserve’s decision to raise interest rates by 75 basis points in June in pursuit of what Capital Economics describes as the most aggressive monetary tightening since the 1980s has caused the greenback /zigman2/quotes/210561789/realtime/sampled USDJPY -0.1521% to rally 17% against the Japanese yen during the first half of the year. This is the largest such move by the dollar against the yen in history, according to Dow Jones Market Data, based on figures going back to the early 1950s.
Against the euro /zigman2/quotes/210561242/realtime/sampled EURUSD -0.9748% , the greenback’s other main rival, the dollar has risen more than 7% since the start of the year — its strongest first-half performance since 2015, when an economic crisis in Greece stoked fears about the possible collapse of the eurozone.
And measuring the dollar’s strength more broadly, the WSJ Dollar Index, /zigman2/quotes/210673925/realtime XX:BUXX +0.65% which incorporates 16 rival currencies into its calculation of the dollar’s value, has risen 8% so far this year, on track for its largest first half appreciation since 2010.
In the currency market, where intraday moves are typically measured in basis points, macro strategists told MarketWatch that moves of this magnitude are more typical of emerging market currencies, not G-10 currencies like the U.S. dollar.
But why is the dollar rising so aggressively? And what does the dollar’s strength mean for stocks and bonds as the second half of 2022 begins?
What’s driving the dollar higher?
With inflation raging at its most intense level in 40 years, the dollar has benefited from two tailwinds this year.
The most important, according to a handful of currency strategists on Wall Street, is the widening differential between interest rates in the U.S., and the rest of the world. Dozens of other central banks (including the European Central Bank) have decided to follow in the Fed’s footsteps by raising, or planning to raise, interest rates. However, real interest rates in the U.S. — that is, the rate of return on bonds and bank deposits when adjusted for inflation — remain more attractive, particularly compared with Europe, where inflationary pressures have been more intense, and the European Central Bank only recently unveiled its plan to embark on interest-rate hikes beginning in July.
In Japan, where inflationary pressures are more subdued, the Bank of Japan has resisted the global trend of monetary tightening and continued to pursue its policy of yield-curve control by buying massive quantities of Japanese government bonds.
But a favorable interest-rate differential isn’t the only factor driving the dollar higher: the greenback has also benefited from a newly acquired “safe haven” status.
According to a model developed by Steven Englander, global head of G-10 currency strategy at Standard Chartered Bank, 55% of the dollar’s appreciation this year has been driven by interest-rate differentials (and, more important, expectations surrounding the path of monetary policy in the U.S. relative to other developed nations) while the other 45% has been driven by safe-haven flows.
Englander and his team developed by the model by comparing the dollar’s performance to simultaneous moves in Treasury yields and U.S. stocks.
“Since mid-March the most reliable indicator of USD strength has been spreads rising and the S&P falling,” Englander wrote in a recent research note introducing his model.
The S&P 500 /zigman2/quotes/210599714/realtime SPX +0.41% has done a lot of falling. It’s down nearly 20% in the year to date through Wednesday, on track for its worst first-half performance since 1970, according to Dow Jones Market Data. The Dow Jones Industrial Average /zigman2/quotes/210598065/realtime DJIA +0.50% was down 14.6% over the same stretch, its worst such performance since 2008.
And investors have found no safety in government bonds, with Treasury yields, which move opposite to price, rising sharply as the Fed moves to aggressively tighten monetary policy.
But even when stocks have fallen and bonds have rallied (bond prices move inversely to yields), the dollar has, more often than not, continued to appreciate. The pattern is clear: since the start of the year, when markets have turned risk averse, the dollar has benefited.