The Trade Weighted US Dollar index has rallied by 25% from the second half of 2014 until the end of 2016 (see Exhibit 1) for three reasons. First, non-US central banks pursued competitive currency devaluation as a tool to fight low inflation. Second, the US Federal Reserve (Fed) started to normalise monetary policy by raising interest rates, turning the US dollar into the third highest-yielding currency within the G10 with interest rates higher only in Australia and New Zealand. Third, after the US elections, market expectations for fiscal policy divergence drove the recent leg of the rally.
Source: Bloomberg, BNP Paribas Investment Partners as of 16 February 2017
Can this rally continue?
After this 25% rally, based on valuation, the US dollar looks expensive, in our view. The Japanese yen is undervalued by 32% versus the US dollar and the Swedish krona is undervalued by 47%, based on purchasing power parity. So the question now is: can this rally continue? It is pretty clear to us that both the Bank of Japan (BoJ) and the European Central Bank (ECB) have moved away from specifically targeting currency weakness and are now more open to allowing their currency to appreciate. Devaluing the currency does not work when everyone is doing it. Even the Swiss National Bank (SNB) was forced to accept a stronger Swiss franc and abandon the floor of 1.20 against the euro.
This shift from explicitly keeping their currencies weak to allowing some appreciation is significant as competitive currency devaluation was the main driver of the first leg in the rally. Furthermore, the recent comments by the US administration about foreign countries manipulating their currencies will make it more difficult for them to openly intervene in the currency markets.
So, if the ECB and the BoJ are not driving the euro and the yen lower anymore, will we see US dollar strength caused by the Fed’s policy?
This looks more likely now than it was last year, in our view. At the beginning of 2016, the Fed had signalled there would be four rate rises by the end of 2016, but it actually delivered only one. However, the three increases expected by the end of 2017 look more plausible. US economic data continues to be firm and the two most recent speeches by Chair Yellen suggest that the majority of the voting FOMC members still expect three rate rises this year. Finally, the case for fiscal policy divergence remains intact, but we will need to see more details regarding any tax reforms by the new administration to be able to better gauge this factor.
We believe the US dollar is already overvalued and one of the key reasons for its rally is no longer valid as foreign central banks are now open to allowing their currencies to appreciate. However, monetary policy divergence is still in place and there are real prospects of a fiscal policy divergence. To us, the US dollar will remain well-supported until foreign central banks also start normalising monetary policy.
Written on 16 February 2017