Jim Iuorio, for CME Group
At a Glance:
- The U.S. dollar’s strength this year is partly due to its performance relative to other devalued currencies
- The dollar weakened to recent lows as the market anticipates rate cuts in September
Since early 2020, the U.S. dollar defied economic expectations by appreciating against most of the world’s currencies. This trend is perplexing given the unprecedented rise in both national debt and the M2 money supply in the United States during this period.
This year, the U.S. national debt has surged to $35 trillion, marking a 50% increase since the start of 2020. Simultaneously, the M2 money supply has expanded by nearly 40%. These figures prompt a crucial question: has the dollar been genuinely strong, or has this perceived strength merely been an illusion?
Defining U.S. Dollar Strength
According to basic monetarist theory, significant increases in debt and money supply should weaken a currency. With more dollars in circulation, each dollar theoretically holds less value, particularly when the supply of goods remains unchanged—leading to inflation. And indeed, inflation did rise.
The crux of the matter may lie in how we measure the dollar’s strength. In finance, currency strength is often gauged relative to other global currencies, a critical concept that impacts global trade and interest rate policies.
In response to the economic fallout from the COVID-19 pandemic, most countries, including the U.S., adopted similar measures to stave off deflationary pressures: cutting interest rates and increasing deficit spending to bolster demand. Initially, the U.S. was particularly aggressive, reducing rates to near zero and enacting massive debt-fueled stimulus packages. As expected, the dollar depreciated by roughly 10% against major currencies, hitting a low around June 2021.
However, the narrative shifted in June 2021 when inflation emerged, signaling that the Federal Reserve would soon begin raising rates. Each month of delay heightened expectations of just how high rates could go. Beginning in February 2022, the Fed embarked on one of the most aggressive rate-hiking cycles in history, raising the federal funds rate from zero to 5.37% in just 18 months. U.S. rates soon outpaced those in most of the developed world.
Recent comments by Fed Chair Jerome Powell have indicated that rate cuts are now imminent, which will likely shift global currency markets yet again.
Alongside the Fed rate-hiking cycle, FX volatility increased materially and CME Group FX futures quarterly average daily volumes reached record levels in Q3 2022, trading over one million contracts per day. While FX volatility has normalized in 2024, open interest in FX futures has continued to grow, reaching record levels of over 2.8 million contracts on June 14.
Carry Trade in Currency Markets
To understand how rate differentials affect currency values, consider the U.S. dollar versus the Japanese yen. After battling deflation for nearly 30 years, the Bank of Japan (BOJ) was more tolerant of inflation than the U.S. The BOJ kept rates in negative territory well into 2024, trying to finally overcome deflation. As a result, the yen plummeted, losing 28% of its value against the dollar before bottoming out in July 2024.
This rate differential has significant implications for currencies due to a phenomenon known as the carry trade. Essentially, entities borrow large amounts of yen from Japanese banks at low rates, sell the yen to buy dollars, and invest those dollars in higher-yielding assets. Over time, this process pushes the low-rate currency further down and the high-rate currency higher.
However, the risk arises when the trade becomes overcrowded, making the market vulnerable to a sudden “unwind” as positions are liquidated. The Euro’s weakness against the dollar followed a similar pattern, compounded by economic concerns over the impact of Russian sanctions on regional economies.
Hedging Potential Dollar Fluctuations
In mid-August, the dollar weakened to recent lows after Powell’s remarks. If a trader believes that the dollar’s improbable run of relative strength is truly nearing its end, they could use CME Group FX futures to manage the risk. July ADV in the FX suite of products increased 9% compared to July 2023 as more market participants used futures to manage risk. If a trader anticipates a reversal of the carry trade and a surge in the yen to continue, they could buy CME Japanese yen futures. Conversely, if they expect continued economic challenges in Europe, they might sell CME euro futures.
Those concerned with ongoing weak currency policies globally, and their implications for continued higher inflation, might also consider traditional inflation hedges like Gold futures or newer alternatives like Bitcoin futures. As the potential for rate cuts look likely in September, potential fluctuations in the dollar will likely remain in focus for many market participants.
