The US Dollar Index (USDX, DXY), made up of only G-10 currencies, has been weakening in fits and starts since the first few days of 2017, when it reached its highest level in 14 years (see Exhibit 1 below).
DXY is down about 10% since the start of the year, contrary to strong expectations that it would rise in 2017. Similarly, the Federal Reserve’s US Trade Weighted Broad Dollar Index (USTWBROA), which includes emerging markets (EM) currencies, is down about 8% since late December 2016 from its highest level in 15 years (see also Exhibit 1 below).
Exhibit 1: Changes in the US dollar and US trade weighted broad dollar indices 1995 through 28/08/17
Source: Bloomberg, BNP Paribas Asset Management, as of 28/08/2017
The main factors that contributed to US dollar weakness in 2017 were:
(1) an acceleration of global growth while US growth remained anemic at around 2% — US GDP was an unusual laggard within the G-3;
(2) shifting monetary policy by a number of key central banks from easing to either a neutral stance or contemplating the start of a cycle of tighter policy;
(3) diminishing political risks in the Eurozone after the French presidential election; and decreased confidence in the Trump administration’s ability to pass its agenda of tax reform stimulus, infrastructure spending, and deregulation as politics soured in the US.
After this recent correction, the US dollar remains about 10% overvalued versus many currencies such as the euro, the Japanese yen, and the British pound based on the Organization for Economic Co-operation and Development (OECD) Purchasing Power Parity valuation measures.
Using different methodologies based on the Consumer Price Index and adjusting for current account balances, the US dollar remains as much as 30% overvalued against the Japanese yen and the Swedish krone. Of course, determining fair value is difficult for currencies, and currencies can deviate by 20% or more from fair value measures for prolonged periods. Nevertheless, most studies currently show that valuation would not be an impediment to a further weakening of about 10% for the US dollar across many major currencies and a large number of emerging market currencies.
We expect the themes which undermined the US dollar so far this year to continue for some time. The major economies of the world are expected to grow for the immediate future, with recession risks at low levels barring unpredictable political or economic shocks. Most importantly, the monetary policy divergence between the US and the Eurozone firmly in place since late 2013 reached an inflection point earlier this year. The Federal Reserve is within a few hikes of reaching a neutral federal funds rate given the low growth/low inflation environment in the US (and the major economies of the world).
By contrast, the European Central Bank has begun reducing its purchases of government bonds in April 2017. It is only expected to start raising rates sometime in 2018, with a cycle that will likely continue for a long time after the Federal Reserve is done raising rates. The European political process may finally have turned a corner with the French election and should gain a stronger footing after the German election in the fall; the days of the sovereign debt crisis and existential fears for the euro project now seem more distant.
Unfortunately the travails of the Trump administration, by contrast, are unlikely to dissipate any time soon. The upcoming year will likely remain as politically difficult as 2017 has been, with an important set of mid-term Congressional elections in November 2018.
In light of the shifting dynamics of economic growth, monetary policy divergence, and domestic politics in the US vs. Europe, as well as the fact that the US dollar still remains overvalued by most measures, we would favor a weakening bias for the US currency well into 2018. The days of exceptionalism for the US economy, monetary policy, and politics appear to be behind us for the medium term.
Written on 28/08/2017