Strength in the U.S. dollar historically leads to anticipation about its effects on commodity prices and the prospects for the emerging markets. However, as monetary policy rates diverge and Europe’s energy crisis intensifies, the dollar’s significant appreciation against the Japanese yen and the euro points to an extending chain reaction. In particular, this post looks at how the ECB may find itself in a situation more akin to emerging market central banks as it faces historically elevated inflation alongside mounting economic uncertainty. While we’re not drawing a direct comparison between European and EM assets, we conclude with some ramifications for the latter in the current cycle of dollar dominance.
The second half of 2022 not only started with another strong U.S. payroll report and a white-hot CPI print that provided the Federal Reserve cover for more significant rate hikes, it also heralded the dollar’s surge into new territory. The latest breakout sparked a jump in foreign exchange volatility that was led by the yen, the euro, and commodity-sensitive currencies (Figure 1).
The Dollar’s Latest Surge Initiated a Jump in Currency Volatility, Taking Real Effective Exchange Rates of Euro and Yen to their Weakest Levels in 20 Years
PGIM Fixed Income and Bloomberg.
One of the common reactions to dollar strength—in addition to its effects on the profits of U.S. multinational firms—pertains to its effect on commodity prices. Historically, the dollar had a negative correlation on commodity prices. Yet, that relationship flipped following the COVID-related stimulus and Russia’s invasion of Ukraine (Figure 2).
In terms of this relationship going forward, a divide is becoming increasingly apparent. There are those observing persistent tightness in physical commodity markets that could keep prices elevated even with the unprecedented strength in the dollar. On the other hand, there are those expecting weaker demand from China and Europe to restrain commodity prices, pushing the relationship between the dollar and commodity prices towards its historical trend, which would play into a damaging feedback loop for commodity exporters that may be similar to the dilemma currently facing the ECB.
The Recent, Positive Correlation Between the Dollar and Commodity Prices (shaded)
PGIM Fixed Income and Bloomberg.
The European Extension1
The effects of the current cycle of dollar strength are extending under some challenging circumstances. In Europe, the ECB faces a complex situation between the need to tighten policy to address rising inflation, which is being exacerbated by the euro’s weakness, while waiting to see whether Germany’s crucial manufacturing sector is shutoff from Russian gas supplies, potentially leading to a troubling period of stagflation.
When walking through a potential scenario pertaining to a sudden-stop of gas flows, we estimate that a 10% increase in energy prices adds about 0.2 percentage points to euro zone inflation in a given quarter, and the increase in inflation could last 12-18 months. Meanwhile, this scenario may translate into a projected euro area GDP contraction of about 5 percentage points from Q4 2019 levels, i.e. a contraction of about 1% in 2022 GDP growth (Figure 3).
Scenarios for Euro Area GDP Projections Through 2023 (Q4 2019=100)
PGIM Fixed Income.
After the euro’s 20% depreciation over the last year brought it to parity with the dollar, the euro could easily test the $0.95 area over the short term if the ECB fails to present a credible plan to tackle the looming risks pertaining to fragmentation, inflation, and decelerating growth (even if good news emerges on the Nord Stream gas pipeline).
Moves in reserve currencies of this magnitude rarely experience a mean reversion, and they tend to remain in place for an extended period of time. For example, the euro previously bottomed against the dollar at $0.85 in June 2001 after declining by almost 30% over the course of two years.
Ultimately, significant overshoots in reserve currencies are often addressed with explicit or implicit interventions. More explicit interventions to address FX divergence include the Plaza Accord in 1985, the Louvre Accord in 1987, or the so-called Shanghai Accord in 2016. From the perspective of monetary policy convergence, although the market expects the ECB to lift rates to 1.75% over the course of the next year, that could still leave its policy rate more than 150 bps lower than the Fed funds rate.
Furthermore, as we stated in a recent piece on the “Fed put,” the inflationary backdrop significantly raises the bar for the Fed to pivot back to supporting growth in the current cycle. Hence, the ECB finds itself in a situation more akin to those in emerging market economies. It is widely acknowledged that it does not currently possess the tools to simultaneously address its looming risks, which leaves the currency as the main shock absorber as it often is in various EM crises.
An EM Extrapolation
Emerging market observers are well aware of the challenges that a strong dollar poses for the sector. Although it is clearly not a direct proxy for the euro area, we see similarities in terms of the feedback loop, and some potential implications for EM currencies and local rates may provide context to the issues unfolding in Europe.
EM currencies face risks in terms of trade balances and macro policies. If dollar strength renews the pressure on commodity prices, the currencies of EM commodity exporters will likely depreciate as well, placing additional pressure on the respective central banks to tighten policy. The macro perspective pertains to China: if the People’s Bank of China adjusts its currency basket to weaken the yuan, that will likely pressure Asian currencies and similarly pressure the respective central banks to tighten policy. It’s a challenging backdrop that keeps us wary of EMFX in the short term.
The view on EM local rates cuts two ways and is complicated by the reaction function likely felt by several EM central banks. At first glance, local yields appear compelling as they’ve crossed the 7% threshold for the first time since early 2016 (Figure 4), hence they may experience periodic rallies. Yet, euro depreciation—driven by the prospects for European stagflation—has pressured EM currencies, such as the Hungarian Forint and the Chilean peso, irrespective of their sensitivity to commodity prices, which places further pressure on the respective central banks to raise rates in order to stabilize the currencies. Hence, while EM central banks were among the first to move against inflation, the focus is shifting away from their inflation-fighting credibility to their ability to maintain financial stability given weakness in their respective currencies. That shift warrants our preference for high-quality local rates, rather than those that are highly exposed to the feedback loop.
Local EM Yield Surge to Multi-Year Highs, But Central Banks May Still Hike Rates to Stabilize Currencies
PGIM Fixed Income and Bloomberg.
Some upcoming events may provide more clarity on the extent to which the ECB is entering its own feedback loop. The ECB meeting on July 21 may provide additional detail on steps aimed at addressing the multiple risks of fragmentation, inflation, and decelerating growth. The reopening of the Nord Stream pipeline supplying gas to the region is another critical milestone. While the path for Europe could become even more fraught if these developments tip the wrong way, markets may increasingly look to the experience of the emerging markets as a playbook regarding how the situation for policy and markets unfolds.
1We’re highly cognizant of the challenges that yen depreciation poses for the Bank of Japan. However, in this post, we focus on the euro depreciation and the challenges for the ECB given its proximity to the war and the region’s broad use of Russian energy exports.