Can the Strong US Dollar Environment Persist?
Yes. The hawkish Federal Reserve and energy market challenges have contributed to a strengthening of the US dollar in recent quarters, and we expect that trends in both factors may continue to be supportive of the dollar in the short term. Nonetheless, on a longer horizon, historical precedents suggest that the dollar is approaching the end of a multiyear bull run.
The most recent leg of dollar strength started in mid-2021. Its 20% appreciation against developed currencies was precipitated by a large increase in inflation that forced the Fed to move meaningfully away from its position of “not even thinking about thinking about raising rates.” With inflationary pressures slower to build in other developed markets, interest rate differentials between the United States and many of its peers widened, which supported the dollar. Short-rate differentials had largely plateaued by March/April, with the notable exception of versus Japan, where the Bank of Japan (BOJ) continued its accommodative policies.
Since then, the worsening energy crisis in Europe has raised questions about European growth and provided fresh support for the dollar. Since March, the consensus 2023 GDP growth forecast for the Eurozone has fallen 225 basis points (bps) to 0.25%, while the same forecast for the United Kingdom has fallen 195 bps to -0.15%. In contrast, analysts only revised down their forecast for the United States by 140 bps to 0.90%. Though interest rate differentials between Europe and the United States have narrowed in recent weeks, this has not acted as a support for European currencies. Being forced to tighten monetary policy while growth is slowing as meaningfully as it is in Europe is not a desirable combination. Additionally, the Fed looks likely to carry out the most durable hiking cycle, with inflation in the United States likely stickier, presenting further upside risks to Treasury yields.
Another consequence of the rise in energy prices has been a swift deterioration in the current account balances of energy importing regions. On a trailing one-year basis, the Japanese, Eurozone, and UK current account balances have declined by 1.7, 2.1, and 2.8 percentage points of GDP, respectively, between second quarter 2021 and second quarter 2022. 1 While Japan and the Eurozone retain a current account surplus, they are likely to become deficits in the coming quarters. Meanwhile, the United Kingdom, which was already running a deficit, has seen this balloon to an estimated -5.4% of GDP. Recent budgetary adjustments have not been helpful to current account prospects, with the United Kingdom’s fiscal stability and external funding requirements being questioned by markets. Current account deterioration represents increased sales of domestic currency to purchase foreign currency, largely dollars, to facilitate continued imports. This transactional flow effect is another headwind to these currencies.
One further support for the dollar has been the elevated level of economic and geopolitical uncertainty. This has stemmed from the economic aftermath of COVID-19 in advanced economies, the advent of war in Ukraine, and the slowdown of growth in China. With rising yields pressuring Treasuries and gold, the US dollar is the last safe haven standing. Russia’s recent rhetoric and decision to draft men suggest these fears may not quickly abate. In combination with an unappealing growth/inflation trade-off in Europe, a BOJ still committed to accommodative policy, and worsening current account balances, continued support for the dollar seems the most likely path for now.
Still, the dollar appears expensive when looking at long-term data. In fact, its real effective exchange rate versus both our developed markets trade- and equity-weighted baskets is at the 100th percentile. The current dollar cycle is also looking a little long in the tooth when compared to the length of the previous two dollar cycles. These cycles lasted 77 months and 115 months, respectively, while the present cycle currently checks in at 138 months. It is a broadly similar story when looking at magnitude. This cycle, the dollar has appreciated by 64% in real terms against our trade-weighted basket, as compared to an average of 68% during the previous cycles.
A catalyst is likely required to knock the dollar off its perch, however, and we can envision several based on present circumstances. A pivot by the BOJ would likely see the yen appreciate significantly. Capital repatriation by Japanese investors could precipitate broader dollar weakness. Europe is already working to sever their energy ties to Russia, and, if successful, European growth may be on firmer footing in one to two years’ time. Perhaps the most likely candidate to cause a dollar reversal, however, is a Fed pivot. It is possible that the lagged impact of high inflation, elevated interest rates, and weak global growth trigger a US recession. If US rate expectations eased decisively in response, this could, after an initial dollar rally, sow the seeds of cyclical dollar weakness.