What Impact Does Inflation Have on the Dollar?

The dollar hovered around a two-week low on Thursday, weighed down by the latest insistence from Federal Reserve chairman Jerome Powell that rate increases aren’t on the radar, while sterling has been riding higher with re-opening optimism.

Overnight, the Fed first sounded confident about the economy in its statement. Then Powell was more circumspect and said in his news conference that rate increases were “a ways away” and that the job market still had “some ground to cover”.

The greenback initially rose following the statement, before retreating to a two-week low of $1.1849 per euro after Powell’s remarks.

Improved market mood after Bloomberg reported China’s securities regulator held a phone call with banks to soothe fears about the recent selloff also put some support behind riskier currencies overnight, analysts said.

“The reaction was to the Powell presser, which was seen as dovish,” said National Australia Bank’s head of FX strategy Ray Attrill. “And improving risk sentiment should be associated with a weaker dollar,” he added, noting the rebound in U.S.-listed China tech names and recent gains in re-opening exposed firms.

The U.S. dollar index fell for a third straight session on Wednesday and hit a two-week low of 92.233, then held near that level at 92.257 early in the Asia session.

“In the short-term, there’s been a reduction of taper fears, and that’s why we’ve seen the dollar heading lower,” said Jeffrey Halley, senior analyst at brokerage OANDA in Jakarta.

“Improving risk sentiment should be associated with a weaker dollar,” added National Australia Bank’s head of FX strategy Ray Attrill.

“We didn’t expect this policy decision to cause too many waves and that’s exactly what it’s looking like,” said Ryan Detrick, senior market strategist at LPL Financial. “The Fed is seeing improvement in the economy, but the economy still needs assistance they’re going to leave rates where they are.”

Still, some see risks ahead as the Fed prepares eventually to start raising rates.

Inflation has dominated investing conversations in 2021. Many countries have rebounded strongly from the COVID-19 crisis and are experiencing significantly higher-than-expected inflation. The annual inflation rate in the United States jumped to 5% in May 2021, the highest level since August 2008.

Inflation Losers

So which sectors suffered the most during the higher inflation regimes? Our analysis of the 30 sectors covered by the Kenneth R. French Data Library found that when inflation exceeded 10%, the worst-affected sectors were those that dealt directly with consumers — consumer goods, autos, retail, etc. Despite their ability to adjust their prices at will, these businesses seem to struggle to pass the increases to their customers.  

A current manifestation of this is the European financial services industry. Banks have hesitated to impose negative interest rates on their retail savings accounts, but nevertheless have charged negative rates on the deposits of asset managers and other institutional customers.

Inflation Winners

The same sectors did not uniformly underperform when inflation hovered between 5% and 10%. Some even generated positive returns. In contrast, the sectors that most benefitted from high inflation were almost identical during the two higher inflation regimes: specifically, energy and materials, which investors often rely on when positioning equity portfolios for higher inflation.

Investors have inflation nerves 

Almost half (46 per cent) of respondents to a UBS study of 2,999 investors and 1,201 business owners around the world think that inflation will pick up speed over the next 12 months, with US respondents being the most concerned. 

Some 46 per cent of those surveyed expect a faster rise in inflation, and 44 per cent expect prices to rise at the same pace. Only 10 per cent predict that it will slow down, according to the UBS Investor Sentiment survey. The study was conducted between 23 June and 12 July. The sample was split across 15 markets: Argentina, Brazil, Mainland China, France, Germany, Hong Kong, Italy, Japan, Mexico, Russia, Singapore, Switzerland, the UAE, the UK and the US. 

The study found that 58 per cent of the respondents thought that it had some impact on portfolios and 26 per cent said it will significantly affect it. 

The survey found that 35 per cent of investors plan to add stocks, 33 per cent plan to add precious metals, 32 per cent plan to add sustainable investments, and 32 per cent are planning to add real estate. While inflation is a concern, global investor optimism remains high on their own region’s economy for the next 12 months (70 per cent) and stock market performance over the next six months (67 per cent).

“Though we expect the recent rise in inflation to ease, the outlook for inflation remains uncertain and, therefore, building inflation protection into portfolios is an appropriate step for investors to be taking now. This includes investing in commodities, private market infrastructure, and stocks with pricing power, as these areas tend to perform better in an inflationary environment and will help to preserve purchasing power over the long term,” Tom Naratil, president of UBS Americas and co-president of UBS Global Wealth Management, said. 

Iqbal Khan, president of UBS Europe, Middle East and Africa and co-president of UBS Global Wealth Management, said: “The Delta variant is leading to renewed worries about lockdowns, inflation has proven to be higher and longer lasting than many thought - among them the Fed - and US/China tensions are resurfacing. 

“It’s no wonder that we see some nervousness and uncertainty amongst investors, particularly in the US and Asia. Our view is that there will be no return to national lockdowns and we’ll see inflation recede in the second half, meaning the Fed won’t need to withdraw stimulus. This should be positive for the re-opening of economies, recovery trades and many of the secular growth winners,” he added.