The big US dollar risk
The US dollar enters 2017 up by 25% against a broad basket of currencies over the last two-and-half years. The single biggest question for investors in the new year must be whether the dollar continues its bull run.
As ever, a case can be made either way. Dollar bears note the currency is overvalued in historical terms, and argue the market is overly fixated on the possibility of “Trumpflation” in the US, while ignoring improved fundamentals elsewhere. Meanwhile, dollar bulls point to widening yield spreads and the likelihood that proposed changes in the US corporate tax code could prove strongly dollar-positive.
The problem is that while the probabilities of the bullish and bearish scenarios may be finely balanced, the macroeconomic risks are asymmetric. A dollar retracement from here would represent a return towards business as usual and would be largely neutral. But a further move higher in an already strong dollar could be very damaging for global trade and capital flows, and for financial markets.
The argument against significant further US dollar gains boils down to valuations. After climbing by a quarter since mid-2014 against both the DXY basket of major currencies and a broader trade-weighted basket, the dollar is now overvalued by most measures. Against the euro, yen and pound, the dollar is now one to 2.5 standard deviations overvalued relative to its average long-run deviation from purchasing power parity.
Similarly, against a broad basket of currencies that excludes the renminbi, the US dollar is now stronger in real effective terms than at any time since 1986 (see the chart below). With the dollar’s strength eroding US competitiveness, the rally is over-extended, argue the dollarskeptics, and a retracement is due, especially against the euro.
The problem with this view is that although exchange rates may revert to the mean in the long run, deviations often go further and last longer than valuation-focused analysis suggests. With US interest rates rising, and yield spreads over Europe and Japan widening, there is a strong possibility that the dollar could move from overvalued to even more overvalued in the course of this year.
The dollar could also get a big boost from tax changes proposed by president-elect Donald Trump and Congress. The Congressional Republican majority is keen to introduce border tax adjustments that would favor US manufacturers at the expense of foreign competitors in order to redress perceived imbalances in the global trade regime. Similarly, Trump’s advisors are discussing what would amount to a subsidy for US exporters and/or a tariff on foreign imports into the US.
Economic theory suggests that if the border tax adjustment is enacted, all else being equal the US dollar would strengthen to a degree that would eliminate any competitive advantage gained by US business. To a certain extent this is already happening, with the DXY US dollar index up by some 5% since November’s election in anticipation of the new measures. Greater policy visibility following Trump’s inauguration on January 20 could add further momentum to the US dollar’s climb.
A move by the dollar into even more over-valued territory would be destabilising in various ways. Additional dollar strength in advance of the tax changes would hammer US manufacturers, leading to a sharp deterioration in the US trade balance that could prompt an even more protectionist response from Washington. And a stronger dollar would inflict severe pain on emerging markets that have borrowed heavily in the US currency in recent years. In short, the consequences of a stronger dollar are far nastier than of a retracement, so it is little surprise that it is the risk of US dollar strength that investors are focused on right now.