The highly valued dollar
Neil Weller, Head of Global FX Strategy
The US dollar has appreciated strongly this year reaching parity vs the euro. We evaluate why this has happened and what could cause this trend to change.
The US dollar is clearly highly valued. In inflation adjusted terms, the trade-weighted dollar is trading within the top 8% of levels seen since the introduction of floating exchange rates in the 1970s.
Our valuation framework also flags the US dollar as overvalued. Such an extreme valuation signal has historically been followed by a major turning point and strong returns for valuation strategies in the subsequent five years.
From a qualitative perspective, the signal from the valuation models appears robust. When a currency is overvalued, we would expect to see a decline in the balance of payments position, led by the goods sector. Over the last two years, this has been the case in the US, with export volumes stagnating and import volumes rising.
However, it is worth taking a step back and examining why the dollar has been so well supported, what conditions are likely to be required before a turning point, and whether this time could be different.
While the Federal Reserve (Fed) has been tightening policy; the Committee raised the Federal funds rate by 0.75% to a range of 2.25%-2.50% at the July meeting, we do not find US interest rates to be a good explanation of dollar strength. In aggregate, interest rate spreads have not moved significantly in favor of the US dollar due to the global nature of the current tightening cycle. Short term market movements have not aligned well with changes in rate spreads. The carry available on the US dollar against low yielding funding currencies does not appear particularly high in risk adjusted terms due to the large increase in currency volatility. Carry-to-risk measures are currently around 0.30, a threshold that has historically been an important indicator of when carry has started to become a theme in currency market movements, but well below the 0.40 to 0.70 levels seen during periods of more intense focus on carry strategies in 2006-2008 and 2018-2020.
A further complicating factor for carry strategies is the impact of the exit from negative rates and unconventional polices. We believe these polices have been significant for currency markets, with a strong relationship between shadow rate measures that account for unconventional policy and the EURUSD exchange rate over the last five years. Negative rates appear to have had a disproportionate impact on flows out of European fixed income, with over EUR 3 trillion of net outflows seen during the period. Looking forward, we expect the return to positive rates to see some repatriation of these outflows, offsetting the carry advantage of the dollar.
We think the more influential factor behind the US dollar’s strength has been its rising safe-haven premium against an environment of high inflation, a major geopolitical shock to energy markets and increasing chances of economic recession.
Firstly, when inflation is high, the historical experience is that duration is a less effective portfolio hedge than in low inflation periods. This differs from the performance of the US dollar, which has historically been negatively correlated to equity markets in both high and low inflation regimes. We believe that the high inflation environment has pushed multi-asset investors into greater US dollar allocations and raised the safe-haven premium on the dollar.
Secondly, the Russian invasion of Ukraine and subsequent disruptions to trade have had a major impact on the prices of a range of commodities, such as energy. With both Europe and Asia reliant on imports of energy commodities, while North America is broadly self-sufficient, there has been a major shift in terms of trade in favor of the US dollar. In recent months, we have seen the impact begin to show in the trade balances of Europe and Japan, with our forecasts projecting further declines due to the lagged passthrough of price increases. These changes in trade flows directly affect supply and demand for currencies, with the US dollar benefitting as the primary currency for commodity trades.
Finally, the global growth outlook has worsened amid the tightening of financial conditions and energy price rises. With recession fears weighing on sentiment towards a wide range of risk assets, we see the safe haven premium in the US dollar as exceptionally high relative to history.
On a multi-year horizon, we do see scope for the elevated safety premium in the US dollar to decrease. We believe that current infrastructure investment projects will narrow the gap between energy costs in the US and Europe by the time they are completed in late 2024, even without any resumption in Russian energy exports. We also expect bonds to regain their negative correlation to equities, enabling the US dollar to share the role of global safe haven asset.
For currency investors with the ability to take a multi-year view, extreme valuations are again likely to provide an opportunity. For those seeking a more tactical approach, the economic headwinds that have supported the US dollar remain a challenge. We currently favor relative value strategies motivated by differing exposures to the energy price shock and seeking to minimize overall beta to risk assets, while keeping a close watch for signs that we have reached the peak in safe haven demand for dollars.