Over the last four years, the U.S. dollar has appreciated sharply. We’ve seen the exchange rate between a basket of major developed-market currencies and the dollar shoot up over 20% since July 2014. After a short break in 2017, the dollar resumed its brisk climb, rising more than 5% in the first five months of this year and triggering concerns among investors and economists about USD-related disruptions to the global economy and financial markets.
This seems to me like a good time to share a few observations about the behavior of the U.S. dollar and also form a view––at least an informed guess––about how things may go from here.
Keep in mind, however, that predicting the timing and magnitude of currency moves is challenging. Most currency models developed by economists cannot even fully explain historical patterns, let alone produce forecasts that can systematically beat the consensus. So it’s important to maintain healthy doses of humility and discipline in designing long-term investment plans based on any projections about the dollar.
Tracing the dollar’s ups and downs
Let’s start with a simple historical observation about the dollar: Since 1973, its value has remained in a relatively tight range compared with other major currencies, except for three multiyear “super-cycles.”1 As you can see in the accompanying chart, we’re in the midst of the third dollar super-cycle right now.
Three super-cycles in the U.S. dollar since 1973
Notes: The U.S. Dollar Index shows the trade-weighted average exchange value of the U.S. dollar against a basket of currencies that includes the euro, the Japanese yen, the Canadian dollar, the British pound, the Swedish krona, and the Swiss franc after adjusting for inflation. Data are from January 1973 through June 2018. The average “normal” valuation was calculated by excluding real dollar index readings above 90.
Sources: Vanguard and the U.S. Board of Governors of the Federal Reserve System.
Different causes, similar outcomes
While the chart suggests a statistical regularity and reversion to the mean, each upswing in the dollar has had a different cause. The magnitude and duration of each upswing have varied as well.
The first big swing, from about 1979 through 1987, coincided closely with Paul Volcker’s tenure as chairman of the Federal Reserve and his fight to bring inflation under control by raising the federal funds rate to 20% in 1981.
The second super-cycle ran from the mid-1990s through about 2004 as global capital poured into the U.S., attracted by the bright earnings prospects for the new IT and dot-com companies. After the 1990s’ bubble burst, and capital inflows eased as U.S.-developed technologies spread to companies worldwide, the markets and the dollar returned to more normal levels.
We’re now in the midst of the third U.S. dollar super-cycle. It started around July 2014, as the Federal Reserve led other major central banks in signaling the end of a period of extraordinarily loose monetary policy.
Because the U.S. dollar is the world’s reserve currency, these super-cycles can send shockwaves across the globe, affecting emerging markets in particular. The 1982 Latin American Debt Crisis, the 1997 currency crises in Asia and Latin America, and the multiple mini-emerging-market crises we have seen since 2014 (in Brazil, South Africa, Argentina, and Turkey among others) have all coincided with peak valuations for the U.S. dollar.
However, while the dollar was at the center of these meltdowns, in almost every instance the ultimate cause of the collapse was those countries’ precarious macroeconomic fundamentals, brought about by dollar-debt-fueled booms (and sometimes further exacerbated by a central bank’s pegging the country’s currency to the dollar). The subsequent unwinding of these emerging-market booms can be fast and furious, but placing blame on the dollar alone misses the bigger picture.
The lesson from these super-cycles is that economic fundamentals drive currency movements. So while it’s commonly believed that strength in the dollar causes weakness in the U.S. economy, it actually seems to work the other way around: The strong U.S. economy (relative to the rest of the world) and the Fed policy that goes along with strong fundamentals have been the primary drivers behind the dollar’s appreciation.
If past is prologue, the dollar will weaken
We can therefore expect the dollar super-cycle to come to a close over the next few years. Here are 4 fundamental factors, not mutually exclusive, that I’ll be watching for:
- Narrower growth differentials between the U.S. and other countries. The U.S. economy is much further along in the business cycle than other developed markets are, its labor market is much tighter, and inflation is much closer to the central bank’s target, which in the U.S. is 2%. Since economic growth normally slows late in the cycle, current growth differentials between the U.S. and other economies are expected to shrink. The next slowdown in the U.S. may be exacerbated when the recent fiscal stimulus wears off. We estimate that the stimulus, injected through the tax cuts and spending bill enacted at the beginning of the year, will deliver an extra push to U.S. economic growth of about 40 basis points this year and next.
- Higher U.S. bond yields, but narrowing interest rate differentials. Higher bond yields in the U.S. today imply depreciation in the U.S. dollar relative to other major currencies in the future. This market expectation may come to pass in the current global monetary cycle as the gap in rates between the U.S. and other major markets narrows. The Fed may stop raising rates as soon as 2019 while other central banks (notably the European Central Bank and the Bank of England) continue to play catch-up.
- Higher inflation in the U.S. Higher inflation in the U.S. relative to other developed markets could put downward pressure on the nominal U.S. dollar exchange rate.
- A larger U.S. trade deficit. For all the noise about tariffs and trade deficits, the natural way for trade imbalances to correct over time is through market-driven currency adjustments. Widening U.S. trade deficits translate into higher demand for foreign currency (to pay for the additional imports), which exerts downward pressure on the dollar. The trade deficits themselves are caused in part by rising government budget shortfalls, which spill over to more foreign purchases of U.S. debt, and in part by strong U.S. consumer spending, which, bolstered by tax cuts, results in more purchases of imported goods, given that they constitute about 18% of the typical consumer basket.
Dollar trends and investing
Dollar moves have significant implications and risks for almost every corner of the capital markets, from emerging-market stocks and bonds, to broader global non-U.S. equities (hedged or unhedged), to commodities.
It’s important to keep in mind, however, that these dollar trends may play out over time frames that don’t match an investor’s needs. Market valuation measures, such as the fundamental factors discussed earlier, are not a good market-timing tool for those with shorter investment horizons. Market prices, whether for equities or currencies, can deviate from fundamentals for much longer than many think.
For investors more inclined to actively position their portfolios based on macroeconomic views, it’s critical to discern which economic trends have already been factored into market prices and which constitute out-of-consensus economic calls. Only the latter will translate into outperformance relative to a benchmark if proven right (or underperformance if proven wrong).
1Why 1973? That’s when the dollar began to float freely after the United States ended its fixed parity with gold, which had been established by the Bretton-Woods Agreement in 1944.