U.S. economic outlook: The U.S. dollar

We expect narrowing interest-rate differentials with the major U.S. trading partners to pressure the dollar lower in the first months of 2024.

We then expect that robust U.S. growth and the opportunity to invest in real assets, spurred by American industrial policy, will drive valuations of the U.S. dollar higher compared with other developed economies. That will work to maintain the dollar’s 15-year uptrend.

The course of U.S. interest rates is as important for the global economy as it is domestically. The 10-year Treasury yield is the benchmark for the global bond market, with short-term U.S. securities facilitating global trading of goods and financial assets and the determination of the dollar’s value.

As with all commodities, a currency’s value is set by the supply and demand for that currency. The intrinsic demand for dollars comes from the high regard for U.S. institutions and the guarantee of payment.

Despite the domestic fiscal austerity and political distortions that have continued since the financial crisis, the dollar has increased in value over the past 15 years, both in nominal and real terms. 

We expect the dollar to retain its underlying value for as long as the U.S. economy continues to grow and for as long as U.S. interest rates are higher than those of its trading partners.

While a stronger dollar lessens the cost of foreign goods for American consumers and pushes down on inflation, a stronger dollar at the same time makes inflation worse for foreign buyers of dollar-denominated goods and services. This is particularly true for nations that are dependent on foreign supplies of fossil fuels.

Changes in the value of the dollar are in part because of interest-rate differentials with other currencies. Investors will put their money in places with the highest return. 

For instance, the dollar’s value suffered during the initial era of zero interest rates after the financial crisis. The dollar’s value then increased in concert with the Fed’s rate hikes from 2015 to 2019, which far outpaced rate increases among developed economies.

The dollar decreased during the trade-war interest-rate cuts and then soared in response to the Fed’s 550 basis-point increase in the federal funds rate beginning in March 2022.

As such, we expect the dollar’s support to soften as the market anticipates the eventual cutting of the federal funds rate.

But even as trading pushes the dollar’s value lower, we can anticipate continued underlying support for the dollar coming from its safe-haven demand in response to the conflicts in Ukraine and the Middle East, and the potential of increased transaction demand for the dollar.

In addition, upward pressure on the dollar will be maintained by the continued attractiveness of U.S. securities for Japanese investors who can chose to invest either in 10-year Japanese government bonds that will be allowed to trade as high as 1% or a dollar-denominated government security or corporate bond trading upward of 6%.