Investing.com – The U.S. dollar has had a tough summer so far, and Capital Economics expects further declines over the next two years, citing unfavorable interest rate differentials and continued strong risk appetite.
The dollar index, which measures the greenback against a basket of six other currencies, has fallen about 4% since July as weaker-than-expected economic activity and inflation data have prompted markets to reassess the path of interest rates in the United States and elsewhere.
“With the US Federal Reserve finally set to begin easing monetary policy, and a soft landing still the most likely outcome for the US economy, we believe unfavorable interest rate differentials and continued strong risk appetite will lead to further weakness in the US dollar over the next two years,” analysts at Capital Economics said in a note dated August 21.
The index fell to its lowest level since late December 2023, although it remains very strong in the long term. With the Fed edging closer to a rate cut, the key question is whether this means the recent weakness in the dollar will persist for much longer.
Evidence from the seven monetary easing cycles since the 1970s suggests that the dollar strengthened for at least a year after the federal funds rate peaked on five occasions following a peak in short-term interest rates—although in three of these cases, the dollar subsequently fell significantly.
Only on two occasions has the federal funds rate peaked and then been followed by a decline in the value of the dollar. The main reason for this pattern is that the Fed’s policy easing has often come in the context of a weak global economy.
Capital Economics believes the US Federal Reserve will cut interest rates more than most of its peers, meaning short-term interest rate differentials will continue to shift against the US.
“This suggests that the dollar will weaken a little,” Capital Economics added.
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