US dollar strength has been building for some time, with the trade-weighted index on an uptrend since mid-2011. However, until the middle of this year the dollar rally had been hesitant, with movements in underlying major currency pairs idiosyncratic. But since early July, the US dollar has strengthened rapidly against a basket of currencies as well as more consistently against the other major currencies. Why is consistent dollar strength happening now, will it continue, and what are the consequences for asset prices?
Recent History
First, for those interested, we provide some background on the moves prior to July. In Japan, the yen depreciated from around ¥78/$ in late 2012 to ¥103/$ by early 2013 due to a radical change in the Bank of Japan’s (BOJ) monetary policy, triggered by the election of the Abe government. The BOJ has embarked on a massive quantitative easing (QE) program that far outstrips the scale of its peers relative to GDP. There is nothing like flooding the market with a large supply of expensive currency to trigger a strong trend move—in fact, the yen weakened against all the major currencies.
The British pound, conversely, had been climbing since mid-2013, reaching a post-crisis high of $1.72/GBP in the summer of this year, pushed up by a strong housing market and talk of likely rate rises before the year was out. The euro also saw a persistent climb for the past two years from $1.20 towards $1.40, baffling some investors who noted continuing depressionary conditions (unemployment close to 12% on average and over 20% in several countries) and the European Central Bank’s (ECB’s) evident displeasure with the currency’s appreciation.
Real Trade-Weighted Value of the US Dollar
January 31, 1973 – September 30, 2014
Why the Rapid Strengthening Since July?
In a nutshell, the rapid deterioration of geopolitical conditions in certain parts of the world and the change in relative growth outlook and monetary policy between the United States and the rest of the world have conspired to highlight the United States as a relative oasis of safety and calm.
Geopolitically, the reawakening of the Russian bear on the eastern fringes of Europe has been a game changer. Though direct effects so far of the proxy conflict in Ukraine have been small, the unfinished business in the region spells more guns, less butter down the line, and serves as a damper on sentiment as the risk of war in Eastern Europe suddenly needs to be factored in. The apparent slow-motion train wreck that is the Middle East—the disintegration of Iraq and Syria as coherent countries and the rise of extremist groups such as ISIS—adds another worry as does the substantial decline in the price of oil.
Economically, while other countries continue to struggle, the US economy continues to add over 200,000 jobs per month on average, boasts one of the lowest unemployment rates amongst developed peers, and has shown decent manufacturing and services growth. These differences in economic growth led the market to believe that central bank policy was about to diverge, with the US Federal Reserve ending quantitative easing in October and assumed to be raising the policy rate by June 2015, while the BOJ and ECB were seen to be continuing to ease or, at best, standing still.
Looking at Japan, after a shot in the arm from the yen’s tumble last year, the Japanese economy has lost momentum, not helped by a consumer faced with higher prices and an increase in the sales tax this past spring. With the pressure on to pencil in further fiscal consolidation for 2015, the expectation is growing that the BOJ will have to ramp up its QE before the end of this year to save the economy. This has started to set in motion a second leg up in the dollar versus the yen.
Exchange Rate Movements
January 31, 2012 – October 21, 2014
In the United Kingdom, no sooner had pundits turned their coats in praise of an economic renaissance, than the shine has begun to come off the data as the housing market shows signs of rolling over and public finances remain in dire straits due to surprisingly weak tax revenue growth. There has been virtually no investment- or export-led rebalancing. All thoughts of imminent rate rises by the Bank of England have consequently been banished over the market’s horizon, triggering an abrupt reversal in the exchange rate.
In Europe, the clouds have darkened once more as France and Italy are stuck in stagnation or renewed recession with no respite in sight. Even the Continent’s growth engine, Germany, has begun to sputter as demand for its famed exports has been impacted by a slowdown in emerging economies such as Brazil, China, and Turkey as well as the fallout from sanctions against Russia. Most concerning, the Eurozone is flirting with outright deflation, Japanese-style, as inflation is a meagre 0.3% year-over-year and trending downward. Given fiscal austerity and an ECB with its hands tied by political constraints, the currency is taking the strain. The worse the outlook, the more expectations of full-blown QE to jump start the Eurozone’s economy rise. Consequently, core Eurozone bond yields have plummeted to about 0.9% at ten-year maturities, way below the ECB’s official inflation target of under but close to 2%. In so doing, the spread over US equivalent bonds has blown out to record highs since the euro’s birth, contributing to the downdraft in the currency.
The United States suddenly appears to be the last man standing in an increasingly dangerous world, and is a coherent continental economy that is relatively insulated from political instability, bad geopolitics, energy dependency, and the depressionary tendencies of its trading partners.
Spread of US Ten-Year Government Bonds Over German Ten-Year Government Bunds
December 31, 1998 – September 30, 2014
How Long Will US$ Strength Last?
The rising US dollar is the market mechanism trying to correct some of the major global imbalances. Put another way, Japan and Europe are exporting deflation through devaluation, and it is not just these regions. Other countries, such as China, have been keen to weaken their (managed) currencies. Even the New Zealand central bank has intervened to cap the NZ dollar. In a world where debtors are still overextended, job markets are unable to employ large proportions of working populations, and wage growth is anaemic or nonexistent in real terms, nearly every country sees salvation in rebalancing towards exports. Obviously this beggar-thy-neighbour approach is futile in a zero-sum game. One can argue about the causes of this lack of demand and risk of deflation, but until a permanent cure is discovered, currency markets will seek to push up the dollar to a level equalizing growth prospects across regions.
It’s a fool’s errand to try to put a precise figure on just how far this current move might go, or, importantly, its speed. We will point out, however, that in the two previous cycles of US$ strength since 1973, the dollar rise has taken roughly seven years to run its course. By that rough approximation, this rally seems to be about halfway through in terms of its duration.
Moves so far in October have seen the US dollar weaken slightly against the major currencies. These moves are likely part of the natural volatility of currency trading and don’t look to us like the reversal of ongoing US$ strength. Some analysts are already pencilling in parity for the euro and ¥120/$ for the yen, and it is undoubtedly easy to construct a worst-case scenario for these major currency pairs. In truth, you can pick any number you like depending on how persistent you believe deflationary forces will be and how you think authorities will react, including the odds for regulatory changes. In the meantime, the knock-on effect on risk assets is real.
What Are the Consequences for Asset Prices?
While we acknowledge that all equities typically perform poorly in a deflationary environment, in a period where the US$ is rising, the US equity market tends to outperform both European and emerging markets equities as the marginal buyer will seek to take advantage of the strong currency. For US$-based investors, dollar strength obviously hurts returns on unhedged foreign equity investments. Finally, real assets with some inflation sensitivity may suffer as the stronger US dollar would tend to dampen both inflation itself and inflationary expectations.
On a positive note, the 20%+ fall in oil prices this year helps to close one of the big savings-debtor imbalances between OPEC and the rest of the world, and will act as a significant boost to real incomes for consumers in countries where prices are set by the market and not dominated by taxes or subsidies. The large fall in government bond yields, the downshift in inflationary expectations, and the probable postponement of rate rises by the Fed and BOE will also have a stabilizing effect not only on sentiment, but on the reality of an extended period of cheap credit availability. Whether this boost to purchasing power will be sufficient to reboot the global economic engine remains to be seen. Failing this, a new round of official stimulus by the major central banks and governments may come into view.
The Bottom Line
Given the economic and geopolitical advantages of the United States, US$ strength is likely to persist for some time. However, this will act as a drag on US growth, bringing down inflation expectations and the forward yield curve. Other things being equal, US$ strength will dampen US earnings and so may require US equity markets to adjust, as valuations appear stretched relative to earnings. Judging from past behaviour, any pronounced weakness in US economic conditions or risk assets as a consequence of a rising dollar could even prompt the Fed to consider another round of QE, perhaps in the form of unsterilized intervention.