Where will the U.S. Dollar Index go in the second half of the year?

Core Points

Global liquidity has entered a tightening range. Inflation triggered by geopolitical conflicts in the Middle East has become the driving force behind the shift in global central bank monetary policies this cycle. Under the pressure of imported geopolitical inflation, re-tightening policies in Europe and Japan have been successively implemented, and the market's mainstream expectation is that the US will restart rate hikes. The CFR Global Monetary Policy Tracking Index covers 54 global economies and measures the overall monetary policy stance on a weighted basis. According to the CFR Global Monetary Policy Tracking Index, many central banks around the world are marginally tightening liquidity. In Q2 of this year, the Global Monetary Policy Tracking Index has slightly crossed zero, entering the tightening range.

During previous US rate hike periods, the US Dollar Index rarely entered sustained unilateral trends. Reviewing recent Fed rate hike cycles, we find that during the rate hike period, the US Dollar Index rarely entered sustained unilateral trends and often fell into oscillation. Only the unexpected preventive rate hike in 1994-1995 caused the US Dollar Index to form a unilateral downward trend. In the subsequent three rate hike periods, the US Dollar Index tended to be volatile. From 2004 to 2006, the US Dollar Index entered an inverted N-shaped oscillation; from 2015 to 2018, it entered an inverted W-shaped oscillation; from 2022 to 2023, under aggressive rate hikes, the US Dollar Index first rose and then peaked and fell.

In the second half of the year, the US Dollar Index may enter a wide-range oscillation phase. The current tightening expectations primarily stem from the impact of escalating geopolitical conflicts on inflation. Compared with February before the conflict, the year-over-year PCE has risen by 1.2 percentage points, with energy contributing over 80% of this rebound. However, this strong tightening momentum may be easing. The situation in the Middle East has seen substantial marginal easing, with oil prices falling back close to pre-US-Iran conflict levels. If the inflationary pressure from geopolitical conflicts is expected to ease accordingly, we believe the Fed's motivation for rate hikes may weaken, and rate hikes could be further delayed. In the second half of the year, as the geopolitical tide recedes, the US Dollar Index will likely enter a wide-range oscillation phase with repeated pullbacks in its operating center.

Main Text

I. Global Liquidity Has Entered a Tightening Range

Inflation triggered by geopolitical conflicts in the Middle East has become the driving force behind the shift in global central bank monetary policies this cycle. Under the pressure of imported geopolitical inflation, re-tightening policies in Europe and Japan have been successively implemented, and the market's mainstream expectation is that the US will restart rate hikes, which may mean that global liquidity easing is officially coming to an end.

As of the end of June, the policy rate directions of major overseas central banks began to diverge. In May this year, among the 49 developed and emerging economy central banks tracked by the Bank for International Settlements (BIS), three raised rates and two cut rates. By June, central banks in developed markets like the European Central Bank and Japan, as well as emerging markets like Indonesia and South Africa, turned hawkish. Among them, the Bank of Japan raised its rate to 1% and announced that it would suspend its bond-buying reduction program starting next year, while the ECB also resumed rate hikes.

Global central banks are shifting from the previous rate-cutting cycle to re-tightening, and the global liquidity easing cycle may be coming to an end. The CFR Global Monetary Policy Tracking Index covers 54 global economies and measures the overall monetary policy stance on a weighted basis. The index ranges from -10 to 10, with greater than 0 indicating a tightening range and less than 0 indicating an easing range. According to the CFR Global Monetary Policy Tracking Index, many central banks around the world are marginally tightening liquidity. In Q2 of this year, the Global Monetary Policy Tracking Index has slightly crossed zero, entering the tightening range, and many central banks have entered a marginal tightening phase.

II. Performance of the US Dollar Index During Previous US Tightening Cycles

What determines the rise and fall of the US Dollar Index is not the Fed's rate hikes themselves, but relative economic strength and expectation gaps. Theoretically, Fed rate hikes are often favorable for the US Dollar Index. In reality, during previous US rate hike periods, the US Dollar Index rarely entered sustained unilateral trends. The US Dollar Index is calculated as a weighted average of the dollar against six major developed country currencies (euro, Japanese yen, British pound, Canadian dollar, Swedish krona, Swiss franc). Therefore, what determines the rise and fall of the US Dollar Index is not the Fed's rate hikes themselves, but relative economic strength and expectation gaps.

1. The stronger the US economy is relative to non-US economies, the more favorable it is for the US Dollar Index to rise. The movement of the US Dollar Index does not depend on the absolute goodness or badness of a single US economic indicator, but on the relative advantage in growth momentum between the US and major non-US counterparties such as Europe and Japan. When the US economy stands out, strong employment and recovery are often accompanied by rising inflationary pressures. This gives the Fed ample confidence to maintain high interest rates and even continue raising rates. At the same time, if non-US economies (such as Europe and Japan) perform weakly, their central banks are forced to maintain low interest rates or even cut rates to stimulate the economy. If the US is raising rates but Europe and Japan are raising rates even more, the dollar will actually fall.

2. For the US Dollar Index to continue rising, new positive expectation gaps are needed. Under modern Fed expectation management, the core market game revolves around the pace and magnitude of rate hikes. If the market has already priced in the future rate path before the first rate hike is implemented, then when the actual move occurs, there are no new expectation gaps, and no additional incremental funds will be attracted to buy dollars, making it difficult for the US Dollar Index to continue rising. At this point, if existing funds take profits and close positions, the US Dollar Index may instead fall. Conversely, if new expectation gaps (positive or negative) arise, the US Dollar Index will evolve in the direction of those expectation gaps.

Reviewing several recent Fed rate hike cycles, we find that during the rate hike period, the US Dollar Index rarely entered unilateral trends and often fell into oscillation.

(1) 1994–1995: An unexpected preventive rate hike caused the US Dollar Index to form a unilateral downward trend. At that time, the US had just emerged from the 1990-1991 recession, with core CPI low and unemployment still relatively high. However, the Fed chose to raise rates to prevent inflation (the policy rate was gradually raised from 3% to 6%). Due to the lack of an expectation management mechanism at that time, the market had not digested the rate hike expectations. After the rate hike was implemented, negative expectation gaps led to turmoil in financial markets, with long-term US Treasuries being sold off. Global capital, fearing that high interest rates would choke off the nascent US recovery, accelerated outflows from the US for safe havens and higher yields. Combined with the strong European economic fundamentals that diverted global capital, the US Dollar Index did not rise but fell instead, continuing to weaken.

(2) 2004–2006: Gradual rate hikes with full expectations led the US Dollar Index into an inverted N-shaped "down-up-down" oscillation. Due to sufficient communication by the Fed beforehand, the first rate hike was already priced in by the market. After the move, with good news priced in, and China driving emerging market economic growth that diverted existing US capital, the US Dollar Index fell. In 2005, when the US was raising rates, the European and Japanese economies were relatively sluggish, and the ECB and BOJ maintained low interest rates without loosening. The US's relative economic strength and interest rates compared to non-US economies strengthened, causing capital to flood back to the US. At the end of 2005, due to a surge in commodity prices (gold, crude oil), Europe and Japan experienced severe imported inflation, forcing the ECB and BOJ to tighten more than expected, causing the relative advantage of the US Dollar Index to peak and enter a unilateral decline.

(3) 2015–2018: Under gradual rate hikes, the US Dollar Index entered a W-shaped oscillation. Before the formal rate hike at the end of 2015, the market front-ran the event, with the US Dollar Index completing an increase from 80 to 100 more than a year in advance. When the first rate hike was implemented, the market entered a "good news priced in" state. In the first half of 2016, the market found the pace of rate hikes very slow, with the Fed keeping rates unchanged for several consecutive meetings, and the actual pace of hikes falling short of hawkish expectations, forming the first bottom of the W. In the second half of 2016, Trump's victory triggered reflation trades, with global capital rushing into the dollar. Thereafter, the largest counterparty, the European economy, experienced an unexpected recovery in 2017. The market expected the ECB to exit QE early and start raising rates, while the Fed's rate hikes were proceeding as planned with no new expectation gaps. Capital flowed from the dollar to the euro, forming the second bottom of the W. In 2018, after the Trump tax cut bill took effect, the US economy performed strongly, while Europe and emerging markets experienced economic downturns due to trade frictions and exhaustion of their own momentum, causing capital to return to the US and pushing the US Dollar Index steadily upward.

(4) 2022–2023: Aggressive rate hikes to combat high inflation caused the US Dollar Index to first rise and then peak and fall. In 2022, after US inflation spiraled out of control, the Fed implemented its first rate hike, and then the pace of hikes exceeded market expectations. Coupled with the European economy languishing in the energy crisis, positive expectation gaps and relatively stronger economic performance attracted capital to buy dollars, pushing the US Dollar Index to a historical high of 114.78. By the end of 2022, the European energy crisis had eased, the economy did not fall into a slump, and the ECB began aggressive rate hikes. At this point, the Fed slowed the pace of rate hikes as inflation peaked, and the benefits from expectation gaps were exhausted, causing the US Dollar Index to decline unilaterally in 2023.

III. In the Second Half of the Year, the US Dollar Index May Enter a Wide-Range Oscillation Phase

The current tightening expectations primarily stem from the impact of escalating geopolitical conflicts on inflation. In Q1 of this year, the market still held expectations for Fed rate cuts, but by Q2, these had shifted to rate hike expectations, driven by the inflationary pressures from the Middle East geopolitical conflict. Compared with February before the conflict, the year-over-year PCE has risen by 1.2 percentage points, with the energy component of PCE contributing 1 percentage point, accounting for over 80%. Thus, more than 80% of this rebound in US inflation is contributed by energy.

However, this strong tightening momentum may be easing. Although the Fed released a signal of possible rate hikes this year through its hawkish dot plot in June, this is essentially a reflection of earlier geopolitical inflation. In fact, in mid-June, the US reached a memorandum of understanding with Iran. According to this document, the US and Iran pledged to negotiate and reach a final agreement within a maximum of 60 days, indicating substantial marginal easing in the Middle East situation. As of June 25, oil prices have fallen back close to pre-US-Iran conflict levels. The average oil price in June was around $87, with a year-over-year increase of about 25%, the lowest growth rate since March this year. Based on this, we believe that the US June PCE year-over-year is expected to follow the decline in energy inflation and fall.

If oil prices return to pre-conflict levels, the inflationary pressure from geopolitical conflicts is expected to ease accordingly. Under such circumstances, we believe the Fed's motivation for rate hikes may weaken, and rate hikes could be further delayed. In the second half of the year, as the geopolitical tide recedes, the US Dollar Index will likely enter a wide-range oscillation phase with repeated pullbacks in its operating center.

Source: Cinda Securities Macro Commentary

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