US dollar exchange rates are key drivers of the global economy and investment markets, particularly given the dollar s status as the global reserve currency. It is therefore important to understand the risks and opportunities that these present to investors, even if predicting direction, strength and timing of foreign-exchange rate movements is notoriously difficult. The US dollar and emerging market currency indices 4 3 1 - -1 1-1 US dollar index US dollar vs. emerging markets (currency index inverted) (RHS) Figure 1: The US dollar has bounced sharply in recent weeks, having weakened significantly against its developed-world peers throughout 2017 and against emerging market currencies since the start of 2016. 3 The dollar strengthened significantly between 2014 and 2016 but a number of domestic factors began to work against it in 2017, causing the trend of appreciation to reverse including overseas developments favouring the dollar ends of foreign exchange rates Context: where are we now? The dollar s strength was driven by the Federal Reserve (Fed) ending its quantitative easing programme and beginning a new rate hiking cycle, at a time when central banks elsewhere in the world were keeping their monetary policy stances extremely accommodative. The trade-weighted dollar index eventually peaked in January 2017, over 4 higher than its post-global financial crisis lows. Firstly, US inflation expectations were tempered by a slew of weaker-than-expected data (Figure 2), which caused the Fed to moderate its guidance on the pace of future interest rate hikes. Although the economy was performing well, expectations that growth would be boosted by fiscal stimulus measures were tempered by political gridlock. The trade deficit also deteriorated towards the end of the year (Figure 3), as imports increased more quickly than exports. At the same time, overseas developments favoured foreign currencies over the US dollar. This was particularly the case in regards to the euro, which appreciated strongly as the threat of deflation diminished on the Continent, causing investors to anticipate a withdrawal of monetary policy stimulus by the European Central Bank (ECB).
US inflation expectations Rate (%) 3.0 2.5 2.0 1.5 Five-year US inflation expectations WTI crude oil (RHS) 100 Figure 2: US inflation expectations moderated in 2017 as inflation data missed expectations. However, they have begun to move higher again as price pressures have continued to build (including higher oil and commodity prices). 90 80 70 60 50 40 30 $ / barrel The US trade deficit $bn / month -35-40 -45-50 -55-60 01/16 07/16 01/17 07/17 01/18 US trade balance US dollar index (RHS) WTI crude oil (RHS) 5 4 3 1-1 - Figure 3: The US trade deficit, which has provided a structural headwind to the US dollar for many years, deteriorated in 2017 as imports rose faster than exports. This was partly because of rising oil prices and a weakening of the dollar. However, if fears of protectionist trade policies cause the deficit to reduce, as they appear to have done in March, this would be positive for the dollar over the longer term. After retracing half its post-financial crisis gains, the dollar began to strengthen again in February this year as a result of both fundamental and technical factors Global purchasing managers indices 60 The tax reforms announced by the US government in December have improved economic sentiment and boosted growth expectations, while the pace of the other major regions expansions has moderated (Figure 4). The inflation outlook has also strengthened as wage growth has edged higher and business activity surveys are indicating rising cost pressures; higher oil and industrial commodity prices have also contributed. As a result, investors have begun to price higher interest rates into asset markets, even as actual inflation data has missed expectations. While demand for treasuries remains strong, some of the technical factors putting upward pressure on treasury yields include higher treasury issuance and the fact that the Fed is reducing the size of its balance sheet. Yield differentials are an important driver of foreign-exchange rates, particularly with investors watching developments in the treasury market closely as the US emerges from an unprecedented period of very low interest rates (Figure 5). Global yield differentials 3 2.5 55 50 45 01/16 07/16 01/17 07/17 01/18 US Eurozone UK Emerging markets Japan Figure 4: So far this year, economic momentum has swung back towards the US, as indicated by the recent changes in regional purchasing managers indices. The US has strengthened, while most other regions have seen activity moderate. Yield (%) 2 1.5 1 0.5 0-0.5 Germany UK Japan Figure 5: The spreads between ten-year treasuries and their overseas equivalents are increasing, providing support to the dollar. The speed of the dollar appreciation post February could be explained by investor crowding. Surveys reflecting speculative investor purchases can be used as a contrarian indicator at extreme levels. In February this year, speculative investors were the most bearish against the dollar since 2011, leaving the currency poised for a reversal, the catalyst being shifting economic growth momentum in favour of the US.
The US economic backdrop should continue to support the dollar through the remainder of 2018 How will the economic environment affect the dollar in 2018? In the absence of a shock event, such as might be provided by the implementation of extreme protectionist trade measures, we expect global growth to remain positive in 2018. Within this backdrop, we expect the US economy to strengthen further, with its ongoing cyclical expansion boosted and extended by the effects of the government s recent fiscal stimulus measures. On top of the additional support provided by stronger growth, base effects associated with rising commodity and oil prices will temporarily put upward pressure on US inflation data over the next 12 months. However, we expect the Fed to tolerate any transitory rise in inflation marginally above its target (up to around 2.5%) without any meaningful change to its monetary policy stance. Overall, the backdrop should allow the Fed to continue reducing the size of its balance sheet while raising interest rates gradually over the course of 2018, as it has been in recent months (figure 6). US interest rate expectations 4 3 Rate (%) 2 1 0 2019 2020 Federal Funds Rate FOMC projection Market expectation Figure 6: Market pricing suggests shows that some investors are wary that the Fed may have to raise rates faster than currently projected. However, we expect US interest rates to rise in line with the Fed s current projections. The removal of monetary policy stimulus outside of the US is likely to take some time Beyond 2018, relative regional growth and policy differentials could begin to work against the dollar particularly if inflationary pressures continue to build outside the US Timing shifts between pro- to antidollar environments presents a key asset allocation challenge Outside the US, growth in some of the world s other major regions has moderated from the strong levels seen around the turn of the year. Nevertheless, it should remain robust over the medium term as there is still significant spare capacity in many developed regions, particularly Europe. While spare capacity leaves room for growth, it should act against inflation and monetary policy should therefore remain highly accommodative outside of the US in 2018. We note that the euro and sterling appreciated significantly in 2017 as the ECB and Bank of England (BoE) slowly began to move away from peak accommodation. While US inflation is likely to temporarily increase in 2018, we expect the Fed to succeed in keeping inflation around its 2% mandate target level over the medium term, particularly as the world continues to face a number of structural deflationary headwinds. We are also cognisant that the US economic cycle has reached a more advanced stage and that the economy s growth rate is likely to come under pressure in time. As such, we believe there is only a low risk that US monetary policy will have to tighten more quickly than the Fed currently forecasts. As spare capacity declines, inflationary pressures will eventually build in the world s other developed regions. This should allow some of the world s other major central banks, most pertinently the ECB, to begin to remove some of the monetary policy stimulus they have had in place in recent years. Both European and Japanese inflation expectations are currently low and the chance that they will increase therefore presents an asymmetric risk for investors, given monetary policy in these regions. As we have previously argued, it is somewhat uncertain when the US economy will face a cyclical downturn, but it is likely that it will do so before Europe. The former s current expansion has been in progress far longer and the amount of spare capacity in the US economy appears to be much lower than in Europe. Nevertheless, even if our central thesis plays out and the dollar strengthens further in 2018, it remains uncertain how much appreciation it will experience. This will be dependent on many factors and we will be monitoring macroeconomic events and data releases closely for clues as to whether the economic backdrop continues to favour short-term dollar strength, or whether it is shifting towards dollar weakness.
particularly given the unpredictable forces that can affect exchange rates Trade presents one such area, given the US s large structural trade deficit Politics perhaps presents the greatest risk to the euro Dollar investors must always be mindful of potential for shifts in risk sentiment There are numerous variables that determine the direction, strength and timing of exchange-rate movements. While it is impossible to predict how all of these will play out, it is important to keep a close eye on those which are having the greatest effect on markets. Currently, two areas of focus include global trade and Italy s political situation. The US trade deficit has improved in recent months after deteriorating significantly towards the end of 2017. It is possible that this is partially because the threat of protectionist trade measures is causing adjustments within global supply chains. The US s large trade deficit provides a consistent headwind for the dollar and if this were to moderate, it would be fundamentally positive for the currency. We note that there are many factors other than policy affecting the US trade balance, for example oil prices and the strength of the dollar itself. In Europe, the evolving political situation in Italy presents perhaps the biggest risk to the eurozone. An escalation of anti-european sentiment could damage stability within the region and catalyse significant capital outflows, as was the case during the European sovereign debt crisis that began in 2009. In this regard, a key area to watch is the emerging markets. The combination of higher treasury yields and a stronger dollar is tightening financial conditions around the world, and this is weighing on the emerging markets. This can lead developed world investors to sell more emerging market assets, with capital repatriation flows further supporting the dollar. This can result in a vicious cycle that exacerbates asset market volatility. Certain economies such as Argentina and Turkey have already begun to show the strain associated with the recent tightening of global financial conditions and investors would be prudent to watch these areas for signs of broader economic contagion. Emerging and developed market performance 5. Emerging market currencies 6 2.5% 4 0. -2.5% -5. 01/18 02/18 03/18 04/18 05/18 Dev-EM relative performance US dollar index Figure 7: Higher treasury yields and a stronger dollar have begun to weigh on the performance of emerging market equities relative to their developed-world counterpart in recent months., MSCI: please see important information - 01/17 04/17 07/17 10/17 01/18 04/18 US dollar-turkish lira exchange rate US dollar-argentinean peso exchange rate Figure 8: The economic pressures associated with tightening global financial conditions are already being reflected in certain emerging market currencies, such as the Argentinean peso and Turkish lira. Conclusion The fundamental backdrop favours further dollar appreciation in the near term. We recognise the fact that the benchmark ten-year treasury yield has recently risen above a key breakout level around 3%; relative rate differentials are likely to remain one of the key drivers of US dollar exchange rates and it is therefore important for investors to watch how yields react around this key level. In terms of asset allocation decisions, we believe a stronger dollar will likely favour developed world equities over their emerging-market counterparts. Beyond 2018, we believe the dollar will face pressure as the world s other major economies play catch up with the US. However, timing this shift will be difficult, particularly far in advance.
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