By Mike Dolan
LONDON- Wasn’t surging inflation supposed to undermine the US dollar?
Be that as it may, the opposite happened this week as news of a surprise spike in US inflation and inflation expectations to their highest in decades sent the US dollar soaring against currencies around the world.
The dollar’s main index zoomed to its highest for the year as the euro and sterling, which make up 58 percent and 12 percent of that index respectively, slumped to 2021 lows.
For some, this made little sense.
There’s a long-standing narrative out there that over-easy Fed money and seemingly endless creation of new dollars via Fed bond buying will eventually fuel inflation and undermine the greenback as the kingpin of the world financial system.
All things equal, higher consumer inflation should be bad for a currency as it means people can buy fewer goods and services for their coin. Allowed to fester, spiralling prices and resulting hyperinflation have in the past rendered national currencies effectively worthless.
Fear of so-called ‘dollar debasement’ has been the stuff of gold bulls for decades, and many have been demanding a return to the gold standard ever since it was abandoned 50 years ago. Lately, cryptocurrency evangelists have taken up the cudgel.
Yet, the failure of bitcoin or ethereum to get excited by Wednesday’s US inflation shock underscored just how patchy the argument for buying crypto as an inflation hedge remains.
And even though gold rose this week, it remains in the red for the year. Long-standing gold bugs and Fed critics, such as Euro Pacific Capital’s Peter Schiff, were left scratching their heads as to why the dollar was rising.
“Today’s dollar rally makes no sense,” Schiff tweeted on Wednesday. “The fact that the dollar is losing purchasing power much faster than expected doesn’t make the dollar more valuable.”
So what gives?
Prosaicly, it’s all just relative. Even if faith in the Fed is in question, foreign exchanges dictate that any loss of the bank’s credibility only matters if it’s more or less than any other central bank out there.
And more posaically still, that all comes down to the basics of where you expect US interest rates and inflation to be relative to those of their major peers a year from now.
This week’s slide in the world’s pivotal euro/dollar pair to its lowest since July 2020 came as the one-year interest rate gap in favor of dollars surged after the inflation data. It’s now added almost 20 basis points to 0.9 percent in just three weeks.
The Fed is now priced to hike policy rates at least twice by the end of next year, starting as soon as July. The European Central Bank barely has one smaller hike priced, but ECB officials loudly insist a rate rise next year is very unlikely.
Whether these rate premiums cover expected inflation differentials is less obvious. They are shy on a one-year horizon – but they do seem to comfortably cover the risk on a 5-10 year view, judging by the relative inflation swaps market.
And more immediately, US economic data is surprising consensus forecasts more positively than the still deeply negative surprises seen in the euro zone. In fact, the gap between US and euro economic surprise indices compiled by Citi is more positive in favor of the United States than at any other point since October last year.
Even though Fed critics like Schiff doubt the Fed will be willing to tighten to the extent the market now thinks, more mainstream investors feel the Fed will react next year and there is much more room to reprice those expectations higher than there is for other central banks.
