Where is the U.S. dollar headed?Contributor Dr. David Kelly
In the short run, exchange rates are often assumed to be driven by expectations on relative interest rate differentials. However, this doesn’t help predict the value of the dollar unless you have a non-consensus view of where those differentials are headed since consensus expectations should already be built into the market. In the long run, more fundamental economic factors should be important, including the U.S. trade deficit and U.S. long-term economic growth prospects. These suggest that, while the short-term trend in the dollar is unpredictable, the long-term trend should be down.
We have seen a quick and meaningful appreciation of the U.S. dollar since mid-2014 of 20.5% versus the major developed currencies and 19.3% versus the U.S. main trading partners. As the right side of Guide page 53 shows, this move has been driven mainly by two factors: interest rate differentials and commodity prices. For developed market currencies, the interest rate differential question has been a major driver. As the European Central Bank and the Bank of Japan have been increasing their QE programs and lowering their interest rates into negative territory, their government bond yields have been decreasing compared to those of Treasuries. This widening gap between Treasuries and German Bund yields has corresponded well with the move down in the EURUSD. For emerging market currencies, commodity price moves have been the major driver of currency weakness.
The key question for the dollar this year is how much more of a role do we expect these two variables to play? With regards to the interest rate differentials, the Fed meeting on March 16 was a crucial development. By revising down their expectations of further hikes this year from four to two, the Fed has effectively decreased the pace of the divergence between its monetary policy and those of other developed central banks in easing mode. The dollar reacted by depreciating in the days that followed. With regards to the commodity question, this current dollar weakness lessens the pressure on commodity prices, such as energy and industrial metals. However, the oversupply issue is still very much prevalent in the commodity market, capping a lot of the further upside. One last important factor for EM currencies this year is what happens with the Chinese yuan. Previous depreciation of the Chinese yuan has corresponded to weakness in other EM currencies as well. With less rate hikes expected from the Fed this year (and thus less pressure on the dollar) there is also less pressure on the Chinese yuan to depreciate, thus also lessening the pressure on EM currencies. Overall, we think it is difficult to predict short-term currency movements, but believe the path of least resistance for the dollar this year is sideways to modestly up, with most of the upside pressure coming from EM currencies.
Over the longer term, fundamentals like the current account balance and investment flows should determine the value of a currency. The current account balance is essentially how much we sell to the rest of the world minus how much we buy from them. Since the U.S. in a net importer, we buy a lot more from than we sell to other countries. Therefore, demand here for foreign currencies is high; we need to buy the things we import and the value of our exports alone doesn't cover it. Theoretically, that high demand for foreign currency in the U.S. should mean we supply more of our currency than is demanded abroad. This oversupply typically means that as our current account deficit gets wider (when the line on the left side of Guide slide 29 goes up), the value of a dollar should fall. If you overlay these two series, you can see that pattern has largely held over the last 25 years. It’s not a perfect relationship, but as the current account deficit remains in negative territory, the dollar should be lower than it is in the medium to long term.
In terms of the importance of the dollar’s move, it is a crucial concept for U.S. corporate profits. As we show on Guide slide 7, U.S. corporate profits have been under pressure over the past five quarters as a result of the strength of the dollar and the weakness in the energy sector. The dollar’s strength over the past few quarters has been a drag on the 48% of S&P 500 revenues that come from abroad. Going forward, some more dollar stability should allow U.S. earnings to improve, leaving us continuing to see opportunities in U.S. equities. Lastly, a more muted pace of dollar appreciation leaves us feeling more optimistic toward emerging market equities, albeit still a bit cautious given the many headwinds facing those countries.
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