Has the dollar peaked?

The dollar has fallen from its September peak near 114.8 on the DXY index to around 105, after a historic rise through 2022 that neatly reflected diverging monetary policy and America's stronger terms of trade. Currency strategists have rushed to declare the top, arguing that peak Fed hawkishness must mean peak dollar. Calling the turn in the world's reserve currency is rarely just a matter of rate differentials, though. It needs a view on how global payment surpluses get recycled and on how short the world is of dollar liquidity.

The first leg of the rally was powered by a Fed that front-loaded its rate rises, widening its policy gap over Frankfurt, Tokyo and London. As the Fed prepares to slow to 50-basis-point increments, that gap will keep widening, only more slowly. The Fed raised rates by 75 basis points at four consecutive meetings from June to November, taking its target range to 3.75-4 per cent. The Bank of England managed a single move of that size in November, its largest since 1989, and the ECB has yet to lift its deposit rate above 2 per cent.

How the peak was made

The top in late September came during a week of extremes. The euro had already fallen below parity for the first time in two decades, Japan's finance ministry had bought yen on 22 September for the first time since 1998, and sterling hit a record low against the dollar after the British government's mini-budget. The reversal since then owes a lot to one release: October's American consumer-price figures, published on 10 November, came in softer than expected, and the dollar suffered one of its biggest daily falls in years.

That sequence matters for the call. Much of the decline so far reflects the unwinding of panic in sterling and the yen, plus a single inflation surprise, rather than any new strength abroad. Moves built on relief tend to stall once the relief is priced.

Money may not go home

The consensus assumes that as foreign central banks catch up, money will flow smoothly out of dollar cash and back into beaten-down international assets. That ignores how uneven national balance sheets have become. Europe's terms-of-trade loss has done lasting damage to its current account surplus, leaving the euro zone without the capital exports it used to rely on.

Likewise, any recovery in the yen depends on the Bank of Japan tolerating higher domestic yields, a shift that carries real risks for Japan's heavily indebted state. The Bank still caps ten-year government bond yields at 0.25 per cent, and Governor Haruhiko Kuroda has shown no sign of abandoning the policy before his term ends in April. Without strong current accounts abroad to support other reserve currencies, the dollar's weakness is more likely a cyclical pause than the start of a long decline.

Who pays for a strong dollar

A dear dollar is a tax on anyone who borrows in it without earning it. Emerging-market governments and companies with dollar debts have seen their repayment costs rise in local-currency terms, and the weakest have already buckled: Sri Lanka defaulted on its foreign debt in May, and several frontier economies have turned to the IMF. Importers of oil and food, which are priced in dollars, have paid more even when world prices eased.

American multinationals are on the losing side too. Profits earned abroad shrink when converted back into dollars, and Microsoft was among the large companies that cut their forecasts this year because of the currency. Japan's finance ministry, which bought yen again in October after its first intervention in September, has shown how far governments will go to slow the damage. A dollar that stays strong keeps all of these pressures in place, while a sustained fall would ease them at once.

Lessons from 1985 and 2008

Past dollar tops offer mixed comfort to the bears. The dollar peaked in February 1985 and it took the Plaza Accord that September, a coordinated push by the five largest economies, to turn a wobble into a multi-year decline. Governments today show no appetite for coordination of that kind, and Washington has no reason to seek it.

The autumn of 2008 is the other lesson. The Fed cut rates sharply after Lehman Brothers collapsed, yet the dollar rallied hard, because banks and companies outside America scrambled for the dollars they owed. It took unlimited swap lines between the Fed and other central banks to calm the scramble, and the same thing happened in March 2020.

The world still needs dollars

The dollar also remains the main collateral currency of global wholesale banking. When growth slows and risk assets wobble, non-bank financial firms outside the US need a steady supply of dollars to service their synthetic liabilities.

The currency's reach is hard to overstate. The Bank for International Settlements' survey this year found the dollar on one side of almost nine in ten foreign-exchange trades, and it still makes up close to three-fifths of the reserves held by the world's central banks. Commodities, trade invoices and cross-border loans are largely priced in it, so demand for dollars rises automatically with global trade and falls only slowly when sentiment turns.

Those liabilities mostly take the form of foreign-exchange swaps and forwards, in which pension funds, insurers and exporters borrow dollars against their own currency for a few months at a time. The positions do not appear on balance sheets in any obvious way, and they must be rolled continually. When lenders become cautious, the cost of rolling rises and borrowers buy dollars outright.

The bearish case deserves a hearing. The dollar is expensive on most measures of purchasing-power parity, American inflation is falling, and a Chinese reopening would lift growth in the economies the dollar has beaten most. If all three held, the decline could run further. The things to watch are the Fed's projections on 14 December, the Bank of Japan's meeting a week later and the cross-currency basis, which shows how much foreigners are paying to borrow dollars.

That offshore short position creates recurring demand for dollars whenever markets turn rough. A lasting top in the dollar will need faster growth outside the US as well as a pause in Fed rate rises, and with no sign of that growth yet, the dollar will probably rally again the next time markets wobble.