- The U.S. dollar has appreciated 6.6% year-to-date.
- The U.S. economy is much further along in the structural healing process than either Europe or Japan.
- We remain constructive on the outlook for the U.S. currency over the medium term, although we do expect some setbacks along the way.
Year to date, the U.S. dollar has appreciated 6.6% on a trade-weighted basis. The U.S. currency has benefited this year from a growing sense that the U.S. economy is emerging from its post-crisis funk faster than other major economies and the Fed will therefore move sooner than other major central banks to normalize policy. More aggressive easing outside the U.S., notably in Japan, has helped the U.S. currency as well. More broadly, though, the U.S. dollar now appears to be behaving with a pro-cyclical bias, an important shift from 2008-2011 when it behaved with a fairly consistent anti-cyclical bias, (i.e., rallying during growth scares and market crises but then declining again during periods of optimism).
We remain constructive on the outlook for the U.S. currency over the medium term. The U.S. economy is much further along in the structural healing process than either Europe or Japan and it is becoming increasingly clear that monetary policy will normalize sooner in the U.S. as a result. This looming policy shift has benefited the U.S. dollar at the expense of other major currencies, and we see this trend continuing over the medium-term. The rapid increase in U.S. oil and gas production is another medium-term positive for the U.S. currency. A secular decline in the demand for imported energy should allow the U.S. economy to grow more quickly with less of the negative impact on the country’s external accounts seen in the past.
But we expect the U.S. dollar to experience its share of setbacks along the way. Based on the Bank of England’s nominal effective exchange rate index, the U.S. dollar is already up about 15% from the historic low reached in July 2011, and up almost 7% alone on a year-to-date basis. While still below its long-run averages, the U.S. dollar is no longer as cheap as it once was. Perhaps more important, the first rate hike by the Fed is still one-and-a-half to two years away. Historically, the U.S. has needed to offer a reasonable yield premium at the front end of the curve for the U.S. dollar to appreciate on a sustainable basis.
This dollar cycle may well be different thanks to the use of unconventional monetary policy in the U.S., but we would be surprised if the U.S. dollar can march steadily higher before actual short-rate differentials shift materially in the currency’s favor. More likely, the U.S. dollar will see a handful of pullbacks along the way, but we would view these pullbacks as buying opportunities as long as our medium-term thesis about cyclical divergence remains intact.