Why the US dollar may be set to strengthen
Barclays expects the US dollar to keep rising as the country’s economic growth gathers pace.
After five years struggling to retain its value against other major currencies, the US dollar now seems to be regaining its strength. It rose sharply in July and August against the currencies of its major trading partners, and especially against the euro. As this article goes to press [as at 19 September], the USD/EUR exchange rate is at its highest level for over a year.
This new trend looks likely to continue The two main influences on a currency’s value are economic growth and expectations of changes to interest rates. Healthy growth prompts central banks to raise interest rates – also known as “tightening monetary policy” – in order to prevent inflation taking hold. Higher interest rates also raise the yield on assets available in the currency, making them more attractive than securities elsewhere. Both the state of the economy and the likely path of interest rates point to a higher dollar.
The economy is getting stronger
The latest data from the US show the economic recovery is gathering strength. For example:
- The Institute of Supply Management index – a widely watched indicator that tracks activity in the services sector – has risen to its highest level in almost nine years
- Consumer confidence has risen to a six-year high. This is especially encouraging news as household spending accounts for around 70% of the US economy
- Another sign of consumer optimism is that car loans are rising at an even faster pace than at the height of the boom in the mid-2000s. As a result, car sales are rising quickly. US light-vehicle sales increased by nine per cent year-on-year in July. In 2014, annual car sales should finally reach pre-recession levels
- A key reason consumers are becoming bolder is that the labour market is improving. This year, the US has seen the healthiest growth in employment levels since the late 1990s
- Companies are also starting to grow bolder. In the past year, there has been a large increase in the pace of mergers and acquisitions activity, while business investment in equipment rose at an annualised rate of seven per cent in the second quarter of 2014. There has also been a rise in the number of businesses applying for loans over the past few months.
Interest rates will soon rise
With the economy looking increasingly healthy, Barclays believes that US interest rates could rise before mid-2015 The US central bank, the Federal Reserve, said recently that it expects to stop intervening in the financial markets via a process known as quantitative easing (QE) by October this year.
QE is a process whereby a central bank injects cash into the economy by buying bonds with newly printed money. This lowers bond yields, or long-term interest rates, encouraging investment.
The Federal Reserve then seems likely to begin raising short-term interest rates, which it controls directly, from historically low levels in the summer. This tends to raise bond yields, or long-term interest rates, too. However, Barclays thinks it may have to raise rates sooner. There are signs that wages could begin to rise strongly in the next few months, which would fuel fears of inflation and prompt the Fed to bring forward interest rate hikes.
The dollar’s rivals look weak
In our view, the US has the strongest prospects of all the major economies, making the other currencies less appealing than the dollar. In the Eurozone, for instance, growth ground to a halt in the second quarter of 2014 and the latest survey data has disappointed. The Eurozone also looks in danger of slipping into deflation. As a result, the European Central Bank is more likely to loosen, rather than tighten, monetary policy.
So the outlook for growth and interest rates in the US bodes well for the dollar Barclays expects it to strengthen over the next year, particularly against the euro.
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