Home > Can the Dollar Strengthen Despite Rising Inflation?

Can the Dollar Strengthen Despite Rising Inflation?

The US inflation data for the past two months revealed the fastest pace of price increases in three decades. Over 25% of all US dollars in circulation were created in response to the COVID-19 pandemic, yet the greenback may stage a strong comeback.

The US inflation is rising at the fastest pace in the last three decades. To many, it is not surprising, considering the extreme monetary and fiscal policy decisions in the United States in response to the COVID-19 pandemic.

All central banks and governments around the world responded in a similar fashion, only that the US went an extra mile. The Fed eased more than its peers, while the US Government delivered the largest fiscal package in the world. Hence, the economic accommodation in the United States led to a declining dollar compared to its peers and rising inflation.

But rising inflation does not necessarily mean that the greenback is doomed. Here are some arguments against such a thesis and why, in fact, excessively high inflation may be a positive for the dollar.

US Headline Inflation vs. 10-Year US Treasury Yield

The first argument for a stronger dollar is the tight correlation between inflation, as measured by the US headline CPI and the 10-year US Treasury yield. The two, as reflected by the chart above, have historically correlated, meaning that higher inflation triggers a rise in yields.

Higher yields, on the other hand, push down the price of bonds – but also trigger an inverse reaction for the price of gold. The yields on the 10-year US Treasury bond and the price of gold have an inverse relationship – when the yields rise, the price of gold declines.

On the other hand, if the price of gold declines, it means that the dollar strengthens. While gold is not the equivalent of the Dollar Index (DXY), its performance/underperformance against the dollar triggered similar reactions from other G10 currencies.

A more accurate approach would be to compare the price of gold with the DXY and interpret their correlation. We see that rising gold prices typically lead to a declining DXY. Also, a decline in the price of gold leads to a rise in the DXY.

Because the euro has the biggest weight in the DXY (57.6%), one may draw the following conclusion: higher inflation triggers a rise in US Treasury yields, a decline in the price of gold, and a move higher in the DXY, with the greenback gaining against the euro in particular.

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