The US dollar’s unexpected strength stands out in the market wreckage of 2018

American surprise.
American surprise.
Image: REUTERS/Eduardo Munoz
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2018 marked the enthusiastic return of volatility to financial markets. Amid all the mayhem one of the biggest surprises of the year has been the strength of the US dollar.

This time last year, the dollar was closing out its worst year in more than a decade. Many expected the weakness to continue as economies around the world grew and the dollar didn’t seem as relatively attractive. Instead, its performance—an index of the greenback has risen 4.6% this year—is a standout in a year that has completely roiled markets.

But you can forgive currency strategists for getting it wrong. This was a challenging year for everyone, whatever you were trading in. At the start of the year, traders, politicians, and businesspeople, were celebrating a synchronized upswing in global growth, buttressed by strong company earnings and record-breaking stock markets. For the first time since the financial crisis, the global economy is “operating at or near full capacity,” the World Bank said.

But the jubilation didn’t last long. Stock markets were hit by a severe bout of volatility in February. The strength of the dollar hit emerging-market currencies hard. The Argentine peso lost more than half of its value by the end of the August. The Turkish lira plummeted. Policymakers in Indonesia, India, South Africa, and Brazil scrambled to protect their currencies. Economic growth slowed down in many regions, contracting in Japan, Italy, and Germany in the third quarter. In the fourth quarter, record-high US stock indexes took a sharp downturn. December has turned into a bizarre and confusing month. In the past week, a measure of volatility in the S&P 500 hit its highest level since 2015.

It’s turned out to be an incredibly hard year for traders to make money. According to Ed Clissold and Thanh Nguyen at Ned Davis Research, 2018 looks set to be the first year since at least 1972 with no asset class returning 5%. That’s everything from stocks and bonds to commodities and real estate. 

Through this, the US dollar managed to do surprisingly well. Growth in China and Europe slowed, in part because of Donald Trump’s trade war, and the US Federal Reserve kept raising interest rates, making the dollar more attractive. Spending increases, tax cuts, and deregulation all helped ensure strong economic growth in the US too.

That said, next year most analysts don’t believe this dollar outperformance can continue. Many traders are on recession watch for the US. Ever since part of the bond yield curve inverted (long-term bond yields going below rates on short-term debt), expectations that the US could fall into recession have become widespread, and could become a self-fulfilling prophecy.

So, what does that mean for the dollar? Traders are betting the Federal Reserve will slow down its pace of interest rate increases, and the central bank has already signaled it will do exactly that. From four hikes in 2018, the latest forecasts by policymakers suggest there will be just two hikes in 2019. With US yields not rising as quickly, there would be less demand for US assets.

Meanwhile, changes in Congress could also mark the end of the strong dollar. When Democrats take over the House next year, it’s unlikely Trump will be able to implement major new fiscal policies to goose the economy, such as big infrastructure spending. Investigations into Trump could also constrain the administration. The year looks set to start off poorly, with the government in a shutdown. Without these fiscal policies, concerns over inflation accelerating too quickly will diminish and further reduce the need for the Fed to raise rates.

Jeffrey Kleintop, the chief global investment strategist at brokerage Charles Schwab, expects the dollar to peak in 2019 as the Fed stops raising rates. At the same time, changes at the European Central Bank, including the end on quantitative easing and a new president, could also lead to tighter monetary policy that advantages the euro over the dollar. Karen Ward, the chief market strategist for EMEA at JPMorgan Asset Management, also forecasts a change in the direction for dollar, as the US economy loses some of its lead over the rest of the world. European and emerging market currencies will benefit, she added in a note to clients.

Analysts at Swiss bank UBS forecast the US dollar index to weaken by 6% next year. “We see the 2018 dollar recovery as mainly a correction within a multi-year bearish trend that likely started in early 2017,” they wrote.  The “exceptionalism” of 2018 was down to important but temporary factors, such as US fiscal stimulus, economic growth slowdown outside of the US, political crises in Europe and emerging markets, and a rise in trade tensions. By the middle of next year, many of these things will have changed and traders will turn their backs on the dollar, which is currently overvalued by some measures.

But if 2018 has proven anything, it’s that reality can pan out very differently to forecasts. Analysts at Barclays warn against being too pessimistic about the Fed’s plans for next year. Bank of America Merrill Lynch notes that it is possible for the US to continue its decoupling from China and Europe. That said, analysts at the US bank are still recommending selling the dollar “judiciously,” believing that most of the dollar’s gains are now in the past.

Here’s a look back at how the dollar performed against the 19 other most-traded currencies in 2018.