Weakness Against Major Rivals Dims Dollar’s Shine

This year has been a tale of two dollars.

The U.S. dollar’s strength has buffeted stocks and bonds in poorer countries, raising concerns that further appreciation in coming months could destabilize the emerging world.

Yet the dollar in recent weeks has slipped against some of its developed-market peers like the euro and yen, even as the outlook for growth in some of those places has started to darken.

Investors now are grappling with the consequences of this split and how likely it is to persist or even intensify. The debate highlights the dollar’s centrality to global markets and the potentially disparate consequences of trade tensions, the U.S. fiscal stimulus and expectations for more interest-rate increases from the Federal Reserve.

A weaker dollar against the yen and euro would likely be an unwelcome development in Japan and the eurozone because the gains in their currencies make exports less competitive and stifle inflation.

But that is the outcome some analysts expect as they look to year-end. The dollar’s strength at the start of 2018 was just a blip in a broader downward trend that began in 2017, these analysts say.

An easing of trade tensions, the ebbing effects of U.S. tax cuts and any hesitation to tighten on the part of the Fed could spur the dollar lower, investors say.

The ICE Dollar Index, which measures the U.S. currency against a basket of six currencies including the euro and yen, has slipped 1.7% from its August peak. Those losses came even as the dollar surged in emerging markets, pummeling currencies such as the Turkish lira, Argentine peso and South African rand.

“We view the dollar strength this year as being a countertrend,” said Jack McIntyre, portfolio manager at Brandywine Global, which oversees $74 billion. In late August, his fund held positions in the local-currency bonds of countries like Brazil, Mexico and Poland, which he believes have been unfairly punished and will rebound over the long term.

“The real trend is a weaker dollar,” he said.

A run of solid economic data from the world’s largest economies has kept the dollar relatively stable against the euro and yen.

In the U.S., Friday’s jobs report showed workers’ paychecks grew strongly, and the unemployment rate remained near record lows. Japan’s economy returned to expansion in the second quarter after a contraction in the first three months of the year. While growth in the eurozone slipped in the second quarter, trade talks between the U.S. and Europe in July took away some uncertainty for the region’s companies, and the European Central Bank’s still-loose monetary policy is likely to support growth in the months ahead, analysts at ING said.

In contrast to the rout in emerging markets, Europe and Japan “are not really freaking investors out at this point in time,” said Kit Juckes, a strategist at Société Générale.

Mr. Juckes estimates the dollar is about 10% overvalued against the currencies of major U.S. trade partners.

At the same time, the selling in emerging markets is unlikely to subside until the Fed indicates it is reaching the end of its current series of interest-rate increases, investors said. The dollar’s gains against those currencies have rattled markets, driving stocks and bonds to multiyear lows. The MSCI Emerging Markets Index last week tipped into bear-market territory, after a multiyear climb.

As U.S. rates creep higher, investors worry that these countries will have a difficult time servicing dollar-denominated debt accumulated in recent years. Yields in emerging markets are also becoming relatively less attractive. Rising rates in the U.S. offer investors a better payout with much less risk.

“The U.S. economy is far from a recession, and the Fed is unlikely to stop tightening just because of emerging markets,” said Adnan Akant, head of currencies at BNP Paribas Asset Management. The selloff “can go on for a while, in fits and starts.”

Federal-funds futures — which traders use to place bets on the course of interest rates — on Friday pointed to an 80% probability of the Fed raising rates another two or more times by the end of the year, compared with a nearly 71% probability a month ago, according to CME Group.

In the U.S., a fall in the dollar could ease pressure on multinational corporations whose earnings have suffered because they need to convert foreign profits into the U.S. currency. Globally, it could buoy commodities like oil and copper, which are priced in the U.S. currency and become more affordable to foreign buyers when the dollar weakens.

Oil prices were up 8.6% from their mid-August lows as of Friday, while copper prices are up 2.4%.

The dollar could still shoot higher if trade tensions mount, said Ben Randol, senior analyst of G-10 foreign-exchange strategy at Bank of America Merrill Lynch. He forecasts the euro will fall to $1.12 against the dollar in the third quarter, from around $1.1550. That dollar strength is likely to be fleeting, however. The bank sees the euro strengthening to $1.20 over the next year.

Write to Ira Iosebashvili at [email protected]

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