Economic insight – who can call the US dollar?

The strength or weakness of the US dollar can have a significant impact on the global investment landscape. In this article we explore the key factors we consider in assessing the likely path for the greenback, which looks overvalued on some measures, but could easily get more expensive.

The difficulty with currencies

Currencies are notoriously difficult to successfully forecast with any regularity, and they can also have a significant effect on portfolio returns, particularly given the elevated volatility we’ve seen in developed market currencies recently.

The focus is now firmly on the US dollar (USD), which has both direct and indirect impacts on the investment landscape, and the future path for the greenback is being hotly debated in investment circles.

In this article we will examine some of the key factors and signals that influence the world’s primary reserve and trade currency, and how these affect our investment strategy.

The impact of a strong US dollar

Clearly a stronger US dollar has a direct impact on sterling-based investment portfolios, in that US equity and bond positions will register a gain on the currency. Similarly, non-US companies that generate a large portion of their profits in US dollars may see a translation benefit.

We saw this in the UK following the EU referendum where sterling fell significantly, but many large, London-listed multi-nationals saw their share price surge on this translation effect. Of course, the reverse is also true for US dollar weakening.

The chart below shows the recent US dollar movement on a trade-weighted basis, putting the recent move in a broader context. The latest rally simply reverses some of the weakness we saw in late 2017 and early 2018, and the USD is some way off the post-election high we saw in December 2016, putting the USD in line with its three-year average level.

Trade-weighted US dollar

As the US dollar is the world’s reserve currency, there are also indirect impacts which can have a very significant and fundamental effect on the economic outlook. A strong dollar is generally bad news for emerging markets, where many governments and corporations borrow in USD rather than their own, less robust currencies. A strong USD can also exacerbate the US trade deficit, as US exports become less attractive and imports more attractive (that is, cheaper for US consumers). It is this point that has helped to inflame the recent trade tensions in the US, where the US President has all but called for a weaker US dollar to promote trade. Indeed, the effect of tariffs is partly equivalent to USD depreciation, in that they artificially increase the cost of imports to reduce demand in favour of domestic producers.

Factors influencing the US dollar

Forecasting currency movements is such an intractable challenge owing to the wide range of factors that need to be considered, the differing timescales involved and the difficulty in estimating the relevant magnitudes in advance. Nevertheless, it is worth covering some of the major points in play, and how these affect our thinking. There are often conflicting signals on currency, and their cyclical nature means the consequences of a currency-positive signal often ends up being negative further down the line (for example, by pushing the currency so high that it becomes overvalued, becoming a ‘victim of its own success’). To add some structure to this discourse, it may help to think about short, medium and long-term timeframes – though in this case long term can be decades, medium term is many years and short term can still be several years! It’s all relative.

Long-term/structural factors

‘Reserve currency’ status

The US dollar dominates global trade and is universally acknowledged as the global reserve currency. Central banks all over the world hold huge sums of US dollar assets in their foreign exchange reserves, many smaller and developing countries either use the US dollar as their main currency or peg their own currency to it.

If you want to trade in international markets, you almost certainly need access to US dollars. This gives the US tremendous power – not only through access to the world’s largest economy, but also by controlling the international trade currency. The flip side of this is that international countries and companies usually find themselves especially sensitive to US interest rates, which are set on the basis of the state of the US economy, rather than the global activity.

A consequence of being the global reserve currency is that there is generally always demand for US dollars to fund a fiscal deficit and a structural bias to run a current account deficit – being the global reserve currency can be a double-edged sword, and this is clearly something the US administration will need to grapple with. The country must consider whether it prefers being a mercantile (preferring a weaker currency and improved trade) or imperial (controlling the global reserve/trade currency and accepting the premium that comes with that) power.

There seems little scope for the US dollar to be replaced as the reserve currency at present, though on a long-term basis, it would seem feasible for the global system to migrate away, though such an effort would certainly not be easy.

Medium-term factors

‘Fair value’

There are many ways to value a currency, but two of the more commonly used measures are based on the Real Effective Exchange Rate (REER) and Purchasing Power Parity (PPP) methodologies.

REER is a market-based approach using the exchange rate between a given currency and a basket of other currencies (typically trade-weighted) which is then adjusted for inflation. Comparing the resulting index to other currencies shows a dispersion which in turn can be used to determine a valuation by reference to a mean.

In contrast, PPP compares the price of a basket of goods in one currency with that of another currency (often the US dollar is used as the comparator) to assess whether the prevailing exchange rate under or overvalues the currency.

The Economist publishes a well-known index based on PPP theory called the Big Mac index – which as the name suggests, simply compares the cost of a McDonald's Big Mac in different countries. For example, at current prices a Big Mac costs US$5.51 in the US and £3.19 in the UK – implying a Big Mac exchange rate of US$1.73 to the pound.

The spot exchange rate at the time of writing is US$1.31, suggesting the US dollar is 32% overvalued relative to sterling (or sterling is 24% undervalued relative to the US dollar) using the Big Mac index methodology.

These measures can indicate whether a given currency is under- or overvalued, and over time we would expect these valuations to mean-revert to fair value. The problem for investors is this tendency to mean revert is often very slow, occurring over many years with a number of cycles occurring within.

This tendency is illustrated in the chart below for the Purchasing Power Parity of sterling compared to USD (based on CPI inflation), showing that deviations from fair value can persist and extend for some time. Therefore whilst REER/PPP valuation signals can be useful strategically, they are of more limited use on a tactical basis.

Sterling Purchasing Power Parity (versus US dollar)

Current account deficit

Much is made of the US current account, with a particular focus, given the recent tensions, on the trade deficit element – but trade flows actually account for only a small amount of currency flows.

For a country like the US, it is the capital and financial accounts (buying and selling of assets) that dominate currency flows. The current account deficit reflects the fact that the US (like the UK) has a domestic savings rate lower than its domestic investment requirements, effectively pulling in money from net saving countries abroad. This investment, it turn, creates a liability to the overseas nation, and will generate an outflowing income stream over the medium term.

Recall above that the reserve currency status means there is high demand for investment into the US (primarily into Treasuries), but the flip side is interest and redemption payments back out. Ultimately the outflow should exceed the initial capital inflow and should therefore be negative for the currency, but this can take a long time for the net effect to materialise, as capital flows into the country to meet investment needs.

The US current account deficit in 2017 was -2.3% (cyclically adjusted). In its annual External Sector Report the IMF considers structural factors to determine what a normal current account deficit should be, and on that basis assesses the current account ‘gap’ to be -1.5%.

However, even if this were to widen significantly from here, the US dollar is typically quite insensitive to current account changes – with a Current Account/REER elasticity the lowest of any country covered in the report, at just 0.12.

Current account surplus/deficit (selected countries)

Interest rate differentials

Interest rates have a variety of impacts on a country’s currency and investments. The US dollar can be somewhat less sensitive to interest rate differentials, since it is not generally a carry trade currency, but the relatively high base rates in the US compared to other developed regions nonetheless has a notable impact.

All else being equal, investments in higher interest rate countries offer attractive returns, drawing investment into the country and pushing up the currency (whilst investors could look to hedge out the currency exposure, hedging costs also rise with interest rate differentials making hedging less appealing).

Note that it is the differential based on expected interest rates, rather than the current base rates that is important, making this element something of a moving feast. Further, at some point higher interest rates should ultimately cause a cooling of economic activity – in this case one would expect investment flows to reverse, potentially flowing to economies with more supportive monetary policies.

Market-implied interest rates

As it stands today, whilst the US has a relatively significant rate differential compared to the UK, the Eurozone and Japan, US interest rate expectations are also arguably priced to perfection, approaching the neutral rate over the next year or two.

Conversely, other regions mentioned are a long way from a neutral monetary policy stance – any catch-up would reduce the interest rate differential, potentially putting downward pressure on the US dollar.

On a related point, past recessions have generally seen the US dollar rally. From an interest rate point of view, many have put this down to relative tightening of monetary policy, as the Federal Reserve (Fed) cut interest rates, just not as aggressively as everyone else.

Conversely, as we stand today, if there were to be a recession before other Central banks had normalised interest rates, the Fed clearly has further scope to cut interest rates than other Central banks, an unusual position which could lead to counter-intuitive currency responses (i.e. the US dollar might end up weakening).

Short-term factors

‘Safe haven’ demand

Inevitably, US assets have strong appeal during periods of risk aversion, particularly as US Treasuries appear to be the one core sovereign bond market that is even close to normalising. Many investors also head for gold (though this has become less the case recently), and as an asset denominated in USD, this will still translate to a dollar-positive trade.

Unfortunately for investors, these short-term risk-off periods are all but impossible to forecast in advance (though commentators invariably find signals to point to with hindsight).

Repatriation

Tax reforms announced at the end of last year have spurred US companies to repatriate some of their cash hoardings overseas back to the US. The magnitude is significant, with a little over US$1 trillion estimated to be held offshore and, thanks to the latest tax changes, much of this is probably going back to the US, in turn having a number of effects.

Firstly, there is likely to be, or to have been, some direct impact on the currency – in reality a lot of this money was probably already held in US dollar assets, just offshore, to minimise currency fluctuations. However, it is also likely that at least some portion has been held in non-USD assets, meaning there is still likely to be a positive currency flow.

Secondly, there is a distinction between ‘onshore’ USD and ‘offshore’ USD. Even though bringing USD assets held offshore back onshore to the US should not have a direct impact on the currency, it does have the effect of reducing the supply of offshore US dollars. This, combined with the stronger US dollar, increases the cost of doing business in the international trade currency for non-USD entities.

Finally there are market and economic impacts depending on what this repatriated cash is subsequently used for, with increased share buybacks and productivity-enhancing capital expenditures expected, improving the relative attractiveness of US equities.

Budget deficit

The planned fiscal stimulus in the US could provide a short-term economic boost, but it is also forecast to see the budget deficit widen from -3.5% for 2016/17 to a peak of -4.7% in 2018/19. This will involve issuing hundreds of billions of additional US Treasuries at a time when the Federal Reserve is reducing its demand for US Treasuries as it unwinds its quantitative easing (QE) programme. The net result is some US$500 billion of additional net debt issuance from the middle of 2017 to the end of 2019.

The good news for the US government is that, as the international reserve currency, there is natural demand for this debt, which limits the impact on yields. However, given US domestic savings are already below investment needs, it is likely that overseas investors will likely be needed to meet this additional supply. The required USD inflow, combined with fiscal stimulus at a time when the US economy is close to full capacity, will likely lead to further deterioration in the US Current Account deficit.

Sentiment

Day-to-day and week-to-week movements are generally driven by the fluctuations in market sentiment, typically in response to isolated events such as economic or company earnings releases, commentary by government officials and prominent business people, news stories and, increasingly, posts on Twitter by the US President. Over time, these will often also form broader trends and themes which can last several months or years, driving flows into or out of the US.

Market signals

Having covered the key factors driving currency movements, it makes sense to look at some of the signals we can infer from markets.

US dollar valuations

Above we covered Purchasing Power Parity as well as Real Effect Exchange Rates, which can give long-term valuation signals, accepting there can be several cycles before these valuations mean revert.

The chart below shows the USD valuation based on Purchasing Power Parity calculations from the Organisation for Economic Co-operation and Developed (OECD) against a basket of major currencies (those used in the DXY trade-weighting basket). It is clear that on a PPP basis the USD looks overvalued against most major currencies (with the exception of the Swiss franc which appears notably expensive on this measure). On a trade-weighted (DXY) basis, the 9% reading is not a negligible overvaluation, but is hardly stretched (compared to the Swiss franc, which is clearly going to be painful for anyone holidaying in the Swiss Alps this year!).

OECD Purchasing Power Parity of USD versus major currencies

Turning to valuation based on a REER methodology, the chart below compares the dispersion of G10 currencies from the mean, based on calculations from the Bank for International Settlements. The z-score tells us how many standard deviations the reading is away from the mean, with a reading above two generally indicating a stretched valuation. USD is certainly getting close to this point on a REER basis, with all other G10 currencies appearing undervalued.

Real Effective Exchange Rates, G10 currencies

Taken together, USD does appear somewhat overvalued on a PPP/REER basis, but the magnitude is relatively limited and such valuations can easily persist or extend over a medium-term timeframe.

More short-term signals can also be inferred from looking at cross currency basis and the speculative positioning in the market.

Cross currency basis

Cross-currency basis is the spread over Libor demanded when swapping USD for another currency in a cross-currency swap, and effectively measures a shortage of US dollars – the more negative the reading, the tighter supply/higher demand is considered to be. Naturally, all else being equal, we can consider such a demand/supply imbalance to put upward pressure on USD until balance is restored (assuming a relative USD shortage). We can see below that, following the recent appreciation of USD, this more short-term measure suggests that excess demand has likely abated.

Cross currency basis (1 yr versus USD LIBOR)

Speculators

Finally, we can look at the Commitment of Traders (COT) report from the US Commodity Futures Trading Commission, which shows the net position of speculators in the US market – that is, investors (typically hedge funds) positioned for a rising US dollar. As these investors build positions, they add upward pressure to the currency (just as speculative buying pushes up stock prices) and vice versa. This can also be used as a contrarian indicator, as it is fair to assume that these investors will need to close out their net long positions at some point to lock in profits (or stop losses!) on a given trade, and less ‘fresh blood’ to perpetuate a speculative bull run. The result is a tendency for mean reversion.

Net non-commercial USD futures outstanding

As we look at the trading positions as at the end of July, we can see that investors have been adding speculative positions on the US dollar – equating to just over US$20 billion – which has helped push the US dollar higher in the short term.

It also means there are fewer marginal buyers amongst the hedge funds, and on this basis some reversion back to a net zero position can be expected at some point in the future, a negative USD signal – though again the position does not look stretched.

Our view

Taking all of the above points together, it is hopefully clear why the outlook for the US dollar is so muddled, with a range of factors occurring over different timeframes – and timing the market is all but impossible. There are inherent contradictions between fundamentals, which would point to US dollar weakening, and flows based on sentiment and investor/corporate behaviour.

On most core fundamentals, and even short-term market dynamics, the US dollar looks somewhat overdone. Valuations metrics such as those based on Real Effective Exchange Rates and Purchasing Power Parity point to the currency being marginally expensive, whilst in the short-term demand for US dollars, implied by the cross-currency basis, has dropped and significant speculative positions will need to be unwound at some point. With US monetary policy looking priced to perfection as other economies start looking to tighten, reducing interest rate differentials would add another downward force on USD.

Staying on monetary policy, there is also some suggestion that quantitative easing programmes, such as the one being undertaken by the European Central Bank, have spilled over into non-euro assets, particularly USD assets. As these programmes unwind, this provides another potential source of USD outflows. Other USD-negative factors include foreign governments looking to rebalance their foreign exchange reserves or even the US President tweeting mercantilist messages about an overly strong dollar and entering a currency war!

The signal from the Current Account deficit is more nuanced. The large deficit is a negative for USD over the long term, but an increasing fiscal deficit may outweigh this in the short term as capital flows rise to meet an increase in investment demand.

Taken together, the above factors suggest the US dollar is overvalued, but none of the measures look stretched, and most importantly there is nothing to stop the currency getting more expensive in the short term. Capital flows typically dominate in the short term, and the US looks a pretty attractive market at the moment. Economic growth is the fastest in the G8, earnings growth is robust and the latest tax reforms are a significant boost.

What’s more, US Treasuries are the only core sovereign bond market where investors are being offered a positive real yield in local currency terms. With US Treasury yields normalising, we also see them regaining their traditional mantle of a perceived safe haven during bouts of risk-off sentiment in the market, which would be a further positive for USD, and the value of this insurance-like quality should not be overlooked.

In conclusion

We actively consider currencies within our investment strategy, though we rarely get a clear enough signal to justify outright currency speculation.

While the fundamentals suggest USD depreciation over the long term, there will likely be several cycles within that, and current USD inflows could push the US dollar higher. The continued strong economic performance from the US and the appeal of safe haven assets, such as US Treasuries, mean it is sensible to include USD exposure as part of a diversified portfolio.

One implication of US dollar strength has been to put significant pressure on emerging markets. Without a clear prospect of USD weakening, the balance of impact-weighted probability has prompted us to reduce some of our overweight positions where appropriate. The downside of any further strengthening looks that much greater than the upside potential of USD weakening at this point.

As always, we will monitor developments in the US dollar, and continue to adjust our strategy as needed.

For more information or if you have any questions please call us on 020 7189 2400 or email contact@tilney.co.uk.