The U.S. dollar has been a standout currency in 2022, rewarding Canadian investors with bigger dividends and an offsetting tailwind for the value of their struggling U.S. stocks and bonds.
But with the dollar trading at multi-decade highs, a number of observers expect that the greenback could be approaching peak strength.
“The U.S. dollar appears quite significantly overvalued,” Shaun Osborne, chief foreign exchange strategist at Bank of Nova Scotia, said in a note this week.
The dollar has shone against a broad basket of currencies this year. The U.S. dollar index is up 16 per cent in 2022, climbing to its highest level since 2002 and touching a new high on Friday.
It rose above par with the euro this summer for the first time in 20 years amid continuing concerns about the European economy as it confronts soaring energy prices and the war in Ukraine.
The key part for Canadian investors: The U.S. dollar rose above $1.35 Canadian on Friday, up from $1.26 at the start of the year and marking a two-year high.
The U.S. dollar this year has also outperformed stocks, bonds, oil and gold, making it a rare winner in a topsy-turvy world. For anyone holding U.S.-dollar denominated assets, the currency tailwind has been a godsend, lifting values and boosting dividends.
But where does the dollar go from here? The answer rests to a large extent on inflation and investor sentiment, with oil prices – once a key support for the commodity-sensitive loonie – likely taking a back seat now that the United States is also an energy-producing giant.
Much of the U.S. dollar’s strength this year has come from the inflation-fighting monetary policies of the Federal Reserve. As the Fed has raised its key rate aggressively to tackle red-hot inflation running at four-decade highs, the dollar has rallied as investors bought higher-yielding U.S. assets, including cash.
Though central banks in Britain, the euro zone and elsewhere have been raising their key interest rates as well, the hikes have been less aggressive.
This week, the Fed raised its key rate by three-quarters of a percentage point, to a range of 3 per cent to 3.25 per cent. That marked the third straight super-sized hike, and when the Fed made it clear that it wasn’t finished, the U.S. dollar zoomed.
The Bank of Canada has also been aggressive with its monetary policy: It also raised its key rate by three-quarters of a percentage point earlier this month, to 3.25 per cent.
But some economists expect that Canada’s moderating inflation and slowing economic activity will temper further rate hikes.
CIBC World Markets recently estimated that the Bank of Canada’s key rate will peak at 3.75 per cent during this rate-hiking cycle. That would be well below the Fed’s peak rate if financial markets are correct in their predictions for U.S. rates topping out at 4.6 per cent early next year.
Financial markets likely have already digested the U.S. outlook though, at a time when other central banks are ramping up their responses to inflation. CIBC expects the U.S. dollar will decline against the Canadian dollar, to about $1.30 by mid-2023.
“With most major central banks now hiking rapidly, and a large amount of Fed tightening now discounted, we don’t expect relative interest rates to move significantly in favour of the dollar over the next year or so,” Thomas Mathews, markets economist at Capital Economics, said in a note.
Mr. Mathews added that interest rates could even work against the U.S. dollar if, as he expects, the U.S. inflation rate soon begins to decline and the Fed shifts its tone toward monetary policy.
Still, it might not be worth giving up on the U.S. dollar just yet: During times of rising risks for the global economy, the greenback remains a popular destination for investors looking for safety.
Indeed, Friday’s market sell-off, which sent the dollar higher, suggests investors are only beginning to come to terms with the threat of a global recession.
“We think the time is coming for a U.S. dollar correction, but dollar bears will have to remain patient for a little longer,” Scotiabank’s Mr. Osborne said.
For now, then, Canadian investors can enjoy those bigger U.S. dividends. But betting on the U.S. dollar rising above $1.40 – pushing the Canadian dollar toward 70 US cents – looks like a long shot.
David Berman