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Gauging the U.S. Dollar Drop

Entering 2017, few strategists’ calls were as unanimous as the view that the U.S. dollar, already at a 14-year high, would strengthen because the Federal Reserve was hiking interest rates while other central banks remained accommodative. In addition, the markets posited that, with Donald Trump’s election, U.S. economic growth would surprise on the upside. Now, the folly of the consensus thinking is clear. The U.S. Dollar Index (DXY) is down 9% from its Dec. 28, 2016, peak of 103.3. So, what happened?

For starters, despite the Fed’s interest rate hikes, the rate differentials with Japanese government bonds and German Bunds were near extremes, suggesting the markets were already reflecting the worst of policy divergence. Next, relative growth differentials surprised; U.S. growth proved much worse than forecast, barely reaching 1% in the first quarter, while growth in Europe and Japan exceeded expectations. 

Lastly, inflation disappointed in the U.S. but held steady elsewhere—an indication that real rate differentials were converging. This allowed the European Central Bank to start talking about tapering its Quantitative Easing, and inertia in Washington dashed hopes of progrowth fiscal policy. 

While a weaker dollar was unexpected, it is welcome. In fact, it has become a critical underpinning of the current “Goldilocks” economy, which is neither too hot nor too cold.

The weaker dollar supports U.S. export growth, which in turn has helped bolster corporate earnings. S&P 500 profits are pacing at some 11% growth for the second quarter—nearly twice the consensus forecast. Of critical importance is the contribution that a weaker dollar has made to global financial conditions, which remain at their most accommodative since early 2014. Ellen Zentner, Morgan Stanley & Co.’s chief U.S. economist, figures that the looser financial conditions have offset nearly 75 basis points of the Fed’s 100 basis points of rate hikes and monetary tightening.

There’s more. The weaker U.S. dollar has bolstered the commodities market, with which it has an inverse relationship. For the emerging market economies, which carry significant dollar debt, the lower dollar allows for sustained capital inflows. Additionally, a weak dollar serves to stimulate economic growth through exports. Finally, while inflation readings have disappointed since February, a weaker dollar should ultimately contribute to driving inflation higher, as it has a three-to-six-month lagged correlation with the Consumer Price Index.

The Dollar’s Next Move

Will the dollar remain weak or rebound? When the DXY hit 103 in December of last year, an analysis based on purchasing power parity and real effective exchange rates suggested that it was roughly 10% to 15% overvalued.

Next, after the U.S. election, euphoria around both future growth and inflation reached extremes, underpinning the dollar surge, but that’s done. Third, with other central banks—most importantly, the European Central Bank—signaling an end to extreme monetary accommodation and gradual policy normalization, interest rate differentials continue to collapse. In addition, relative growth around the world is converging as the U.S. recovery matures and non-U.S. regions come back from multiyear recessions. Ultimately, we see the dollar weakening against the euro as real rates in the Euro Zone become more positive and strengthen versus the yen because inflation in Japan is picking up due to accelerating wage growth.

Despite our expectation for dollar weakness, technical and sentiment indicators suggest the potential for a near term dollar rebound. MS & Co. Global Currency Strategist Hans Redeker notes that bearish positioning in the futures market shows the most extreme negative view of the dollar since April 2009. During the next three to six months, Redeker expects the DXY to retrace toward the 96-to-98 area from today’s 94—a perfect level at for maintaining a Goldilocks economy.

Index Definitions

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Risk Considerations

Investing in currency involves additional special risks such as credit, interest rate fluctuations, derivative investment risk, and domestic and foreign inflation rates, which can be volatile and may be less liquid than other securities and more sensitive to the effect of varied economic conditions. In addition, international investing entails greater risk, as well as greater potential rewards compared to U.S. investing. These risks include political and economic uncertainties of foreign countries as well as the risk of currency fluctuations. These risks are magnified in countries with emerging markets, since these countries may have relatively unstable governments and less established markets and economies.

Value investing does not guarantee a profit or eliminate risk. Not all companies whose stocks are considered to be value stocks are able to turn their business around or successfully employ corrective strategies which would result in stock prices that do not rise as initially expected.

Growth investing does not guarantee a profit or eliminate risk. The stocks of these companies can have relatively high valuations. Because of these high valuations, an investment in a growth stock can be more risky than an investment in a company with more modest growth expectations.

Equity securities may fluctuate in response to news on companies, industries, market conditions and general economic environment. Companies paying dividends can reduce or cut payouts at any time.

Asset allocation and diversification do not assure a profit or protect against loss in declining financial markets.

Because of their narrow focus, sector investments tend to be more volatile than investments that diversify across many sectors and companies. Investing in commodities entails significant risks.

Commodity prices may be affected by a variety of factors at any time, including but not limited to, (i) changes in supply and demand relationships, (ii) governmental programs and policies, (iii) national and international political and economic events, war and terrorist events, (iv) changes in interest and exchange rates, (v) trading activities in commodities and related contracts, (vi) pestilence, technological change and weather, and (vii) the price volatility of a commodity. In addition, the commodities markets are subject to temporary distortions or other disruptions due to various factors, including lack of liquidity, participation of speculators and government intervention.

The indices are unmanaged. An investor cannot invest directly in an index. They are shown for illustrative purposes only and do not represent the performance of any specific investment.

The indices selected by Morgan Stanley Wealth Management to measure performance are representative of broad asset classes. Morgan Stanley Wealth Management retains the right to change representative indices at any time.

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