Dollar Bounces Back and Looks Poised for More Gains

Dollar Bounces Back and Looks Poised for More Gains

Expectations that the Federal Reserve will raise rates at a faster pace this year have been driving dollar’s gains

The dollar rally that started early in the second quarter is showing little sign of letting up, an unexpected reversal after the U.S. currency slumped for most of the past year.

The WSJ Dollar Index, which measures the currency against a basket of 16 others, rose 5.1% in the second quarter and stands near its highest level in a year. The dollar rose 5.5% against the euro and 4.2% against the yen in the second quarter.

Driving those gains are expectations that the Federal Reserve will raise rates at a faster pace this year in response to a robust U.S. economic expansion that has outpaced growth in Europe and other regions. Higher rates make the dollar more attractive to yield-seeking investors.

The dollar’s surge—along with signs that the U.S. economy is strengthening while growth in other major economies is slipping—is helping draw global investors to U.S. stocks and bonds. U.S.-focused equity funds attracted $3.2 billion of inflows in the second quarter, compared with $25 billion in outflows for Europe-focused funds, according to EPFR.

But a stronger dollar can hurt economies in the developing world, making it more difficult for governments and companies to service their dollar-denominated debt. Countries with large current account deficits, such as Argentina and Turkey, have suffered particularly big currency declines in recent weeks.

A rising dollar also can weigh on the prices of raw materials, most of which are priced in dollars, which become more expensive to foreign investors when the U.S. currency rises. Copper has fallen 2.3% in the second quarter, while gold stands near its lowest level since late 2017 after a 5.4% drop.

“When it comes down to it, the world doesn’t like a stronger dollar,” said Kit Juckes, a strategist at Société Générale.

Several factors are behind the dollar’s rally. Many investors started the year believing that a global recovery would shift growth momentum from the U.S. to the eurozone, which experienced its biggest economic expansion in a decade last year. That growth abroad punished the dollar, which fell 0.4% in the fourth quarter.

Yet eurozone data has been uneven during the last few months, and European Central Bank officials said in June they didn’t expect to raise rates at least through the summer of 2019. Meanwhile, the Federal Reserve signaled a faster pace of rate increases this year, spurred by stronger growth in the U.S.

Expectations that U.S. yields will rise while borrowing costs elsewhere are making the dollar more attractive to investors seeking yield.

As U.S. borrowing costs rise, “people ask themselves if they really want to be invested in risky instruments, or in the U.S., where they can earn a decent return for much less risk,” said Ben Randol, senior analyst of G-10 FX Strategy at Bank of America Merrill Lynch.

Investors have also sought refuge in the dollar amid an intensifying trade conflict between the U.S. and China. Many believe a prolonged conflict between the world’s two largest economies will initially have a larger impact on growth in Europe and Asia.

An escalation of trade-war rhetoric would likely accelerate the dollar’s appreciation, especially against the currencies of export-dependent countries such as Canada and Australia, analysts at Bank of America Merrill Lynch said in a note to clients.

The dollar is up 1.9% against the Canadian dollar and 3.7% against the Australian dollar in the second quarter.

BNP Paribas expects the dollar to get a lift from U.S. companies repatriating cash from abroad to take advantage of a Republican tax holiday signed into law in late 2017. The bank estimates that companies repatriated around $160 billion in the first quarter.

At the same time, the dollar could be vulnerable to easing trade tensions and the efforts by the U.S. administration to talk down the currency, they said. A stronger dollar hurts U.S. companies by making their products more expensive abroad.

Some think the dollar rally won’t last much longer. Analysts at TD Securities believe growth will soon pick up in Europe and Asia, making the dollar a less attractive.

“The best days of the dollar’s bull market lie in the past,” said a TD Securities report. “If global growth resets higher in the second half,” the report said, “then we think the dollar will suffer accordingly.”

Analysts at Standard Bank believe the strengthening dollar will likely push the euro down to as low as $1.10 in coming months, from around $1.17. Over the next year, however, they expect the euro to rise to around $1.30 against the dollar, as fiscal and trade deficits in the U.S. undermine confidence in the country’s economy.