Aaron Costello
Answers to our clients’ questions about market action and the market environment in a few paragraphs every two weeks.
We still expect a rising US dollar over the coming year or so; however, the currency is entering the final phase of the strong-dollar cycle and investors should be aware that valuations and historical cycles suggest USD weakness over the coming decade.
After weakening for most of 2016, the US dollar sprang back to life following the November US presidential election, reaching new highs for this cycle in early January. Although the currency has been choppy so far in 2017, we expect the dollar to rise further on the back of Federal Reserve tightening and political uncertainty in Europe. Protectionist policies from the Trump administration also have the potential to send the dollar higher, at least in the short run.
From a big-picture standpoint, the US dollar is expensive, but not yet excessively so. As we discussed a year ago and in our recent currency chart book, history implies a peak in the dollar at some point in 2018, as the current dollar rally has not yet matched previous cycles in either duration or magnitude.
A 2018 peak also fits the narrative of continued Fed rate hikes amid increased fiscal stimulus and tax reform in the United States. As part of broader US tax reform, House Republicans have advanced the possibility of a border adjustment tax. Essentially a tax on importers and a subsidy to exporters, such a tax system could shrink the US trade deficit and, in theory, send the US dollar higher. Indeed, the House version of the tax plan assumes the dollar will rise meaningfully to offset the impact on import prices. But a strong rise in the dollar would be counterproductive, as it would hurt both US and global growth, potentially triggering a recession, and force the Fed to ease monetary policy as an offset. Although the dollar typically rallies amid recessions, the loss of the dollar’s yield advantage would set the stage for subsequent weakness. The disruptive nature of the border tax is why the plan has met resistance in the Senate and from business leaders. Thus, its passage is far from guaranteed.
Even absent a border tax or meaningful fiscal stimulus, the Fed seems convinced that current US economic strength justifies higher interest rates, and a hike is widely expected at the conclusion of the Fed’s meeting on March 15. Rising US rates will help drive the US dollar higher so long as the European Central Bank (ECB) and Bank of Japan (BOJ) continue to keep rates near zero. Eventually, growth in Europe and Japan will cause inflation to rise and force their central banks to tighten. And that might occur at the same time the Fed decides it has hiked enough. The shift to tighter monetary policy seems unlikely in 2017, given the political uncertainty in Europe and that the BOJ has yet to hit its inflation target. But global inflationary pressure could mount in 2018, and see the dollar peak as the ECB and BOJ become hawkish.
Another factor that could drive the US dollar in the near term is the possibility of trade wars. If protectionist policies in the United States escalate into a trade war with China, renewed renminbi weakness would likely result, accompanied by a flight-to-safety driven rise in the dollar as risk aversion hits global markets. The same could be said about renewed Eurozone break-up fears, should politics in Europe turn messy.
However, any surge in the US dollar from current levels will only sow the seeds of its own demise. A 10% rise in the real value of the dollar would put the currency well above the 90th percentile of its historical valuation range and near previous peaks. At that point, investors should prepare for eventual USD weakness by either adjusting currency hedge ratios or increasing exposure to relatively attractive non-USD assets. Of course, the dollar could rise higher and for longer than previous cycles, but it is unlikely investors will be able to time the FX cycle perfectly, so reducing exposure amid any further strong gains is the prudent thing to do. Nothing goes up forever.
Aaron Costello is a Managing Director on Cambridge Associates’ Global Investment Research team.
Originally published on March 14, 2017
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