FX Outlook 2016: The peak in the U.S. dollar
How high can the U.S. dollar go?
The trade-weighted dollar bottomed in late 2011 and has been appreciating since then. It is some 5% below the previous peak of 2002, which suggests that the dollar’s ascent against the major currencies is getting long in the tooth and valuation is becoming a headwind.
Trade-weighted U.S. dollar exchange rate index (narrow)
Source: Thomson Reuters Datastream as of Oct. 15, 2015
USD and group of three: Euro, yen, sterling
While the greenback is fairly valued against the pound, it is 10% rich versus the euro (EUR) and 20% rich versus the Japanese yen (JPY) according to purchasing power parity as of Dec. 11, 2015. However, previous dollar cycles suggest that developed market currencies have a tendency to overshoot fair value by 20% to 30%.
For the dollar to reach its 2002 valuation peak requires good support from sentiment and cycle factors, which we think will be forthcoming in the first half of 2016 due to policy divergence. The U.S. Federal Reserve will probably continue raising interest rates while other major central banks are still easing policy or standing pat. If previous cycles are a guide, the EUR/USD exchange rate could drop to around parity and USD/JPY could reach 125 before the dollar bull cycle ends. Due to its high valuation, the pound (GBP) is most at risk and GBP/USD could fall to 1.40.
Even after two years of weakness, we think that commodity-related currencies (the Australian, New Zealand and Canadian dollars) remain vulnerable to further softness in the prices of their main exports, mostly raw materials.
The terms of trade of these economies (the ratio of export prices to import prices multiplied by 100) are important determinants of currency valuation. A fall in the terms of trade is usually associated with a fall in the exchange value of the commodity currencies. Unlike the euro and the yen, the commodity currencies are not considered significantly undervalued against the dollar yet, because their devaluation over the last two years has roughly been commensurate with the fall in their terms of trade.
Emerging market currencies
Emerging market (EM) currencies in our view could fall further against the dollar than those of the major developed countries. Much of that risk is due to weakness in the Chinese yuan.
The dollar peg put in place by China after the global financial crisis led to strong real appreciation of the Chinese yuan over the last five years. We think that the Chinese currency could be around 10% overvalued. To restore competitiveness and boost its economy, we think that China is likely to embark on a gradual depreciation of the yuan in 2016.
In the short-term, weakness in the Chinese Yuan could drag down other EM currencies. However, some of the other emerging market countries have seen their currencies fall to attractive levels. Sometime in 2016, we expect to see the start of a multi-year period of EM currency outperformance.
Where could we be wrong?
We see two main risks to the central scenario outlined above:
- The U.S. economy could be too weak in 2016 (or the European and Japanese economies too strong) for policy divergence. In this case, we could already have seen the peak in the dollar against the majors. The other safe-haven currencies like the euro and the yen could strengthen in the first half of 2016.
- If the global economy falls into recession, China commits a major policy mistake, or the fundamental imbalances in EM are more severe than we currently realise, the turnaround in EM currency performance we expect for later in 2016 will not materialise.
We see 5% upside potential for the trade-weighted U.S. dollar against developed market currencies and 10% against emerging markets. However, we think that this dollar strength is mainly going to play out in the first half of 2016. Sometime later in the year we expect to see the peak in the U.S. dollar bull cycle and the start of a multi-year period of EM currency outperformance.
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2016 Annual Outlook