The U.S. dollar has continued to strengthen since our previous quarterly market outlook report and exposed fault lines in emerging markets. As EM currencies generally move in unison against the dollar, investors in EM assets are vulnerable to pronounced dollar strength because of their direct foreign exchange exposure. Secondly, EM equity and bond prices generally go down when the U.S. dollar climbs, creating a double whammy for foreign investors who incur currency losses and suffer declines in security prices. Turkey and Argentina are two countries that have been at the center of recent market turmoil. Large current account deficits make both economies susceptible to sudden bouts in risk aversion in global markets. A rising dollar also increases the local currency cost of servicing dollar-denominated debt.
Below, we evaluate the arguments for and against continued U.S. dollar strength.
The bullish case for the U.S. dollar
Short- and long-term interest rates are significantly higher in the U.S. than the other G41 economies, reflecting a U.S. economy that is comparatively stronger than other developed nations. Empirical academic work suggests that high-interest rate currencies generate higher returns in the long run2 than those with low interest rates. The theory of interest parity predicts that a currency with a higher interest rate would depreciate to exactly offset its yield advantage against a lower interest rate currency. On average, our research shows that is not the case as high-interest rate currencies depreciate less or sometimes even tend to get stronger.
- Recent economic data suggests the U.S. economy may be close to full capacity, which in turn could cause inflation to accelerate and the Fed to keep on tightening policy. As the other G4 central banks are expected to hold interest rates constant at lower levels, we believe the rate differential between the U.S. and other major economies is likely to grow over the next 12 months.
- As a large closed economy, the trade war that has been initiated by President Trump arguably hurts the U.S. the least, benefitting the dollar and hurting the currencies of export-dependent economies such as China, the European Monetary Union (EMU), Japan and Canada. If trade tensions escalate further, investors may seek refuge in the greenback as a safe-haven currency.
The bearish case for the U.S. dollar
- Valuation is unfavorable for the U.S. dollar. As of July 2018, the Bank for International Settlement’s real trade-weighted U.S. dollar index against developed-market currencies is 13% above its average since 1994.
- In our view, the strength of the U.S. dollar in the first half of 2018 was driven by better economic data in the U.S. relative to the other G4 economies. The chart below shows that the Citi Economic Surprise Index for the eurozone and Japan significantly underperformed that of the U.S. counterpart until mid-June. Economic surprise indices measure whether published data beats or falls short of industry consensus expectations. Since mid-June, economic surprise indices for the three regions have converged around zero. We believe the euro and Japanese yen will benefit from the closing of the economic surprise gap.
Citi Economic Surprise Indices: Gaps close
Source: Thomson Reuters Datastream, last observation September 11, 2018. Indexes are unmanaged and cannot be invested in directly. Performance quoted represents past performance and should not be viewed as a guarantee of future results.
- Regarding sentiment, long positioning in the dollar has become one-sided, which we interpret as a contrarian indicator. Data from the U.S. Commodities and Futures Trading Commission as of September 13, 2018 indicates the speculative net long position in the U.S. dollar index future has reached 60% of open interest, close to its historical high. One-sided positioning makes the dollar more vulnerable to bad news on the U.S. economy.
All in all, we think that positive influences for the U.S. dollar are mostly reflected in the price, and as a result we’d resist the temptation to chase dollar strength.
1 The G4 comprise the United States, the Eurozone, Japan and the United Kingdom.
2 See for example Engel (1996): “The forward discount anomaly and the risk premium: A survey of recent evidence”, Journal of Empirical Finance