China’s new currency strategy is lending the dollar additional strength that may keep U.S. interest rates lower for longer.
The nation’s devaluation of the yuan comes at a time when the Federal Reserve’s own dollar index, which puts the biggest weight on the Chinese currency, surpassed its high in March. That was when the Fed fired the first of a series of warnings that a stronger dollar, which makes U.S. goods more expensive overseas, may harm growth by slowing exports.
While the effect of a surging trade-weighted dollar may not appear in the economy soon enough to deter an imminent rate increase this year, it’ll limit how far and fast the Fed can go, according to State Street Global Advisors Inc. A 10 percent appreciation in the dollar contributes to a 0.7 percentage point decrease in gross domestic product over two years, according to a New York Fed research.
“If the dollar is much stronger and they’re on the fence about hiking rates, they can certainly push that out to see the impact,” said Collin Crownover, State Street’s Boston-based head of currency management. “If you do see significant dollar strength after the first hike, to me it almost certainly would push out the second hike into 2016.”
While the yuan’s tumble eased Thursday, the slump is far from over, if the currency’s level versus its trading partners is any guide. China’s real effective exchange rate, a trade-weighted measure adjusted for inflation, climbed 13 percent over the past four quarters and was the highest among 32 major currencies tracked by Bank for International Settlements indexes.
China’s central bank said this week it will allow the market to play a bigger role in determining the yuan’s exchange rate. Analysts at Royal Bank of Canada, who predicted the currency’s move, said the yuan was 15 percent overvalued before the Aug. 11 devaluation.
The Fed’s trade-weighted broad dollar index has gained 2.7 percent this quarter, adding to the 17 percent rise since the end of June 2014. The recent slump in the yuan, which accounts for 21 percent of the gauge, won’t be reflected in the index until Aug. 17.
China’s new currency regime may fuel further dollar strength as a weaker yuan has already begun to set off a round of competitive depreciations among Asian currencies against the greenback. A five percent decline in the Chinese currency will translate into a 2.6 percent gain for the broad dollar, Nomura Holdings Inc. estimates.
On March 18, a few days after the dollar rose to the strongest in more than a decade, Fed Chair Janet Yellen said at a press conference that the stronger greenback was contributing to weaker exports and would be a “notable drag” on growth this year. Policy makers subsequently lowered their forecasts for the fed funds rates by almost half. Fed officials next meet Sept. 16-17 in Washington.
“The Fed decision is already tricky, as economic momentum is mixed depending on which data you look at,” Jens Nordvig, a managing director of currency research at Nomura, wrote in a research note. “A batch of further significant dollar gains would be another reason to be cautious.”