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.
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