Since it was allowed to flow freely in the 1970s, the US dollar has tended to follow a pattern of long term cycles, and on average goes up or down for durations of seven years. In this article, Bilal Hafeez, Head of Fixed Income Research, EMEA, explains why he believes the US dollar is likely to be at the beginning of a multiyear downturn.
If you track the US dollar over the past ten years, it becomes clear that we are at the start of a downturn cycle. The currency hit a low in 2011, and since then has risen around 40 per cent against a broad basket of currencies. The factors that affect these shifts are usually a combination of valuation extremes, current account dynamics and the Fed’s action.
The dollar has reached an overvaluation extreme against most currencies including the yen, the euro, the pound, and the Canadian dollar. According to the Purchasing Power Parity, a theory of how the cost of identical goods in different countries should cost the same no matter how you do the currency conversion, the US dollar, on average, was 20 per cent overvalued against the aforementioned currencies. The valuation extremes we are seeing usually indicate the US dollar has gone up too much and the trend is soon to reverse.
Growing US current account deficit
The US current account, the value of goods and services it exports minus its total imports, is currently running a three per cent deficit. In the last thirty years, whenever the US account deficit reaches “extreme” levels-between 2.5 to three per cent-would indicate the dollar is in the proximity of a multi-year peak.
The last time the dollar has reached a multiyear peak in 1985 and 2000, the US was also running a current account deficit between 2.5 to three per cent.
The rest of the world is catching up
The dollar tends to perform very well when the Fed is tightening policy and other central banks are easing. A trend we have seen in the last couple of years is the interest rate divergence between the Fed and other central banks such as the Bank of Japan and the European Central Bank. Whilst the Fed started tapering in 2013 and hiking in 2015, the other central banks were still loosening policy. The divergence propelled the US dollar higher - allowing it to appreciate against other major currencies
However, as synchronised global recovery is under way and other central banks are now moving towards unwinding. The Fed is no longer alone in tightening policy. This removes one major support for the US dollar and makes the dollar particularly vulnerable even if the Fed was to hike further.
Which currency would be the biggest winner against the dollar?
The Trump effect
The election of President Trump has brought trade to the forefront of US policy. We believe that, in order to improve its own trade balance, the US would encourage the dollar to be much weaker than it currently is. To put this into perspective, Germany currently has the largest current account surplus in the world and the US has one of the largest deficits with the euro area. Some combination of a stronger euro, more European imports from the US and less European exports to the US would be needed to narrow the trade deficit. With the Trump administration having started various trade investigations, markets may soon start to focus on any required weakness in the dollar (strength in euro) to correct trade imbalances. Therefore, we believe the euro will be the biggest winner against a weaker dollar.
Macro in focus again
Political uncertainty at the start of the year has also subsided. With the French (and Dutch) elections out of the way without any “shock” outcomes, we believe markets will likely focus more on macroeconomics again. This again is good news for the euro as the European macro recovery would likely provide a positive backdrop for a stronger euro in the coming months.
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Head of Fixed Income Research, EMEA