Since the end of the Bretton Woods exchange rate regime in 1973, the US dollar has undergone protracted periods of appreciation and depreciation on foreign exchange markets. Such periods have been associated with a wide dispersion in the returns of various asset classes at both global and national levels with performance depending on the particular factors driving the dollar’s valuation on exchange rate markets.
The dollar trade-weighted index shows periods of broad dollar strength and weakness, but this index masks the considerable variations in the performance of various currencies against the dollar over these same periods. While some commentators have attempted to identify patterns of regularity in the US dollar’s value, the reality is that there is considerable variation in the length of time and by how much the dollar remains strong or weak.
In analysing currencies we focus on valuation, monetary policy and market positioning. Among these factors, real exchange rates usually act as long-term anchors for exchange rate valuation, while monetary policy responses and market positioning are stronger determinants of exchange rates over the medium and shorter term. Indeed, the transmission mechanism for correcting large misalignments in real exchange rates is normally via changes in monetary policy as a result of the exchange rate influencing the output and inflation variables that help define how central banks will react. So the dominant factor in dollar movements over the medium term has tended to be the relative monetary stance of the US Federal Reserve (the Fed) versus those of other central banks.
With the Fed expected to pursue a relatively tight monetary stance compared with that of many other countries we believe the main driver for the US dollar in coming months across a variety of scenarios will be the theme of divergent monetary policy.
While there are many scenarios that could be used to model an environment of protracted dollar strength and its impact on various asset classes, we have focused on three scenarios that are all underpinned by divergent monetary policy for modelling such an impact over the next one to two years. In all cases our focus is on the broad impact of US dollar strength on the salient asset classes.
In those scenarios where we forsee tighter US monetary policy there is a clear signal that US equities are likely to underperform European equities and to a lesser degree a number of emerging equity markets. Similarly, US debt markets are likely to underperform the Japanese and European debt markets. Only under a scenario involving the Fed reversing course in the wake of an exogenous shock would US government bond and equity markets outperform foreign markets.
To some extent we are confronted with a new paradigm regarding commodities and their relationship with the US dollar due to China’s integration into the world economy over the last 15 years. A very aggressive tightening of US monetary policy in absolute terms would be damaging to commodity prices as would a policy reversal by the Fed following an exogenous shock.
A period of US dollar strength is, in our view, unlikely to be accompanied by strong Australian and New Zealand dollars. The composition of the US dollar bloc has undergone a structural change with the advent of NAFTA and China’s integration into the world economy. In addition, some Asian countries such as South Korea and Taiwan are likely to change their foreign exchange rate regimes and break with the US dollar as it appreciates over the next two years. If China were to be the source of an exogenous shock in the global economy it could drastically modify its exchange regime via significantly wider renminbi bands or abandon the peg altogether.