Don't Overestimate the speed of US dollar's decline

Key words

• Markets expect the dollar to see a significant decline in interest rates due to the decline in inflation.
• Analysis indicates that the US dollar will decline significantly due to the reduction in interest rates.
• Uncertainty about the decline in US inflation, the strength of the Japanese yen, the upcoming US political election scene, and other major central banks raising interest rates may slow the decline of the dollar at the expected speed.

In 2022, specifically since September, the dollar index reached its highest levels since 2002, when it exceeded 112 points, and although it has declined since that date until September 2024 to 102 points, this level is still the highest for the index since 2016, which confirms the strong upward path of the dollar index, which has stabilized above 100 points since the Federal Reserve decided to raise interest rates to confront the highest inflation in forty years.

Since Federal Reserve Chairman Jerome Powell declared during the recent Jackson Hole conference that it was time to launch an easing monetary policy, everyone has raised their expectations for deeper interest rate cuts, with Fed Watch pricing tool estimates - before the release of both unemployment and inflation data in September 2024 - indicating that interest rates on the dollar will decline by 1% by the end of 2024, reaching 3.25% by the end of 2025.

All these expectations and hopes pinned on interest rate cuts have led many to expect that the US dollar will begin its decline journey starting from the next Federal Reserve meeting on September 18, conditional on a decline in the most prominent reason for raising interest rates, which is the inflation index, whose reading for July stands at 2.9%.

Supporters of the dollar's decline also see another reason, which is related by its second most important component, the Japanese yen, which represents 14% of the dollar index, especially after the Japanese Central Bank decided to make a major change in its easing monetary policy, represented by negative interest rates that began in 1999 and ended with raising interest rates in March 2024 for the first time to 0.10% and then to 0.25% in July of the same year, and with the rise in inflation rates in Japan, which have remained low for decades, the Japanese central bank did not hesitate to declare that it is largely open to future interest rate hikes on the yen, especially with the issuance of indicators confirming the possibility of rising inflation, the latest of which was the rise in the wage index, which will consequently increase the value of the yen against the dollar.

The decline of the dollar... but!

All the above expresses reasons that explain the expectations of a decline in the dollar and its index, but these expectations must be calmed to make them more rational, by thinking deeply about the causes of the potential strong decline in the dollar that the markets are seeking.

As for the upcoming decrease in US interest rates, as previously mentioned, it may seem exaggerated for several reasons, the most important of which are:

• Inflation has not shown any indication of a decline to the required 2% levels and has not stabilized at them continuously for a long period.
• Other economic indicators that either Feed or weaken inflation have not yet given any stable signs of a clear matter that the Federal Reserve can rely on to reduce interest rates in the hoped-for manner.

Even assuming the Fed is committed to reducing interest rates according to the current schedule, the dollar’s ​​decline may be postponed until after the end of the fourth quarter of 2024, as markets will have priced in these low interest rates in advance, which will push the dollar’s ​​decline to later times in 2025, as per analyst.

 Also, on the US political front, the dollar will need a clearer picture of the next candidate, whether in terms of Kamala Harris, who promises tax cuts for individuals, threatening an important source of government revenue, which may make relatively high interest rates a tool that the US government uses to finance itself and protect itself from any other government shutdowns, Although this possibility is less harmful to the dollar given Harris' program, which promises to raise taxes on corporations.

The dollar will also need a clearer picture if Trump returns to the presidency, which analysts indicate may lead to the return of inflation through his protectionist and hostile policy towards global trade by raising tariffs that will lead to raising prices or inflation again. 

As for the other major currencies that make up the dollar index (euro, pound sterling, Swiss franc, Canadian dollar, and Swedish krona), with the exception of the yen for the reasons mentioned above, their central banks are also open to further interest rate cuts (since they preceded the Federal Reserve in cutting their interest rates), which will cause the dollar’s ​​strength to decline in general.

Conclusion

Based on the above, the issue of expecting a significant decline in the dollar must always be linked to economic indicators and the performance of the US economy, which is offering distinguished performances in terms of economic growth (represented by GDP) compared to the shock facing other competing economies, which is growth driven by the technological and industrial revolution that may benefit itself from lower interest rates (regardless of its impact on the presidential election programs promised by the Democratic and Republican candidates), which will lead either to an increase in demand for the dollar as a financing currency on the one hand and a strong economic currency on the other hand.