THREE THINGS THAT DRIVE THE DOLLAR AND WHY IT COULD WEAKEN OVER THE NEXT TEN YEARS

Three Things That Drive The Dollar And Why It Could Weaken Over The Next Ten Years

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00:00 Global Demand for Assets (Priced in $)
00:37 Interest Rate Differentials (1st driver)
1:27 Economic Crises (2nd driver)
2:00 Demand for US Stocks (3rd driver)
2:10 Quick Summary
2:33 Dollar Outlook Going Forward

Here’s what drives the dollar, and where it could go from here.
Like anything else, currencies are driven by supply and demand. When people around the world want to buy things that are priced in dollars, like U.S. stocks, bonds, real estate, or whatever, they need dollars to do that. In order to get them, they have to SELL other currencies and BUY dollars, which drives the dollar up.
So what REALLY matters for dollar strength or weakness is global demand for assets priced in dollars.
Demand for U.S. assets has been rising for 3 main reasons over the past 15 years, which is why the dollar has strengthened by over 35%, as you can see by the green line which shows the price of the dollar index using the numbers on the right.
The first, and MOST IMPORTANT reason for dollar strength has been interest rate differentials… which just means the difference between the interest rates you can get on U.S. government bonds vs. other bonds.
Think about it… if you can get a HIGHER yield on a U.S. treasury bond than a U.K. gilt or a German bund EVEN AFTER the cost of hedging your currency, why wouldn’t you do it?
Many foreign governments, institutional investors, and sovereign wealth funds bought treasuries for exactly that reason, which was a key source of the dollar’s strength.
You can see the relationship pretty clearly from the chart where the black line is the interest rate differential between U.S. and Eurozone bonds, and the green line is the dollar index. From 2009 to 2012, as the interest rate differential fell, the dollar weakened, and then from 2012 to 2020, as the interest rate differential rose, the dollar strengthened.
You may have noticed there have been two periods when this relationship DIDN’T hold up, and that brings us to the 2nd driver of dollar strength… economic crises.
If you focus in on the periods around 2008 and 2020, you can see that the interest rate differential fell, but the dollar strengthened.
That’s because the dollar is seen as a safe haven asset, so in times of panic, people usually park money in ultra-safe U.S. treasury bonds. What does that rising demand for U.S. assets do? It drives up the dollar. Also, it lowers the rates on bonds cuz remember, when bond prices go up, yields go down… and all that extra demand for treasury bonds drives their prices up.
The third reason for dollar strength over the past 15 years is demand for U.S. stocks, which have done WAY better than non-U.S. stocks, causing TRILLIONS of dollars to flow into the U.S. stock market and driving up the dollar.
To sum up our key points, currencies, like everything else, are driven by supply and demand. When people buy U.S. assets, they have to buy dollars to do that, so the dollar has strengthened due to higher demand for U.S. stocks and bonds.
And demand for U.S. stocks and bonds has been driven by strong U.S. stock returns, increasing interest rate differentials between U.S. and non-U.S. bonds, and a couple economic crises.
So where do we go from here?
Well, for about the last 7 months, the dollar has weakened because people have been expecting U.S. interest rates to fall MORE than European interest rates… aka the interest rate differential has been narrowing.
However, right now the market is ALREADY PRICING IN that the Fed is going to cut interest rates a lot by the end of the year.
There’s just one problem with that… the Fed is saying they’re NOT going to do that.
So I see two ways forward in 2023. Either the market realizes the Fed is NOT bluffing and they DON’T cut rates as much as expected, which would increase the interest rate differentials and likely drive up the dollar, OR we get an economic crisis, and they DO cut rates a lot… but what happens in an economic crisis? The dollar strengthens.
In my opinion an economic crisis is pretty much the ONLY way they would cut rates a lot this year. Remember, they cut rates to stimulate the economy and they raise them to fight inflation. Well, if inflation is above their 2% target, then they shouldn’t be cutting right? Ideally they’d still be keeping them high so inflation keeps falling. The ONLY way inflation falls to 2% or they decide to cut rates while it’s still higher, is if the economy, and specifically the job market, weaken significantly. THAT would only happen in an economic crisis, which typically causes the dollar to strengthen.
Over the longer-term, like the next few years, I DO think the dollar will weaken.
It goes back to the same drivers that made it so strong the (ran out of space)

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