/Is The U.S. Dollar Nearing A Peak?

Is The U.S. Dollar Nearing A Peak?

By Kathy A. Jones

A long, slow bull market

Is the U.S. dollar topping out? After a long rally, it has backtracked a bit and not made much headway against other major currencies. However, it has appreciated against emerging-market currencies, which suggests there still may be room for the bull market to run.

Between 2011 and 2017, the dollar advanced by about 37% against a broad basket of currencies, marking the third long-term bull market for the dollar in modern history. Since then, the dollar has stalled, but not given up much ground. Unlike the previous two bull markets, this one has been slower and more prolonged, but the magnitude is similar to the late 1990s’ advance.

There have been two major bull markets for the dollar in recent history

The U.S. dollar experienced a major bull market relative to a basket of foreign currencies, from 1979 to 1985 and from 1995 to 2002.

Note: The U.S. Dollar Index (USDX) is an index (or measure) of the value of the United States dollar relative to a basket of foreign currencies. Currencies included in the index are the euro, the Japanese yen, the British pound, the Canadian dollar, the Swedish krona and the Swiss franc.

Source: Bloomberg, monthly data as 2/28/2019. Past performance is no guarantee of future results.

However, the performance of the most commonly followed dollar index (DXY) may not be the best metric for tracking the dollar’s performance. The currency markets have changed along with the global economy over the years. Emerging-market countries now represent a far larger share of the global economy and world trade, making their currencies more significant when measuring the dollar’s movements. Over the past few years, the dollar has continued to gain versus emerging-market currencies even though it hasn’t moved much versus the other major currencies.

The dollar’s value has grown against emerging-market currencies during the past few years

The value of the dollar against the Trade-Weighted U.S. Dollar Index: Other Important Trading Partners has risen from 121.86 index points on July 29, 2011, to 169.15 points on November 23, 2018.

Note: The Trade-Weighted U.S. Dollar Index: Other Important Trading Partners is a weighted average of the foreign exchange value of the U.S. dollar against a subset of the broad index currencies that do not circulate widely outside the country of issue. Countries whose currencies are included are Mexico, China, Taiwan, Korea, Singapore, Hong Kong, Malaysia, Brazil, Thailand, Philippines, Indonesia, India, Israel, Saudi Arabia, Russia, Argentina, Venezuela, Chile and Colombia.

Source: Federal Reserve Bank of St. Louis. Trade Weighted U.S. Dollar Index: Other Important Trading Partners, Index Jan 1997=100, Daily, Not Seasonally Adjusted (DTWEXO). Weekly data as of 2/28/2019.

It’s all relative

The major drivers behind the dollar’s bull market have been the relatively strong performance of the U.S. economy, and higher U.S. interest rates compared to other countries. Typically, countries with higher interest rates and stronger growth tend to have stronger currencies because they attract foreign capital due to a higher expected rates of return on investment. That has been the dollar’s story as the global economy emerged from the financial crisis.

Economies outside the U.S. have been slower to recover, and central banks in Europe and Japan have kept interest rates low or even negative in efforts to boost economic growth. Consequently, holding other major currencies like the euro or yen is unattractive to most investors compared with holding the dollar. Even at the low rates offered in the U.S., the difference is significant. Interest rate differences can be a major driver of relative currency valuations. As currency valuations are all relative, there has to be an attractive alternative to the dollar for investors. That doesn’t appear to be on the horizon in the near-term.

U.S. Treasury yields are higher than those in most other major countries

The yield on the U.S. 10-year Treasury bond was 2.7% on Mar. 1, 2019, higher than yields in Canada, the UK, France, Germany, Japan and Switzerland, and only slightly below the 2.8% 10-year Italian government bond yield.

Source: Bloomberg. Data as of 3/1/2019. Past performance is no guarantee of future results.

Lower ahead?

Recently, there have been signs that the dollar could be topping out. The Federal Reserve has signaled a pause in its rate hikes amid signs of slower growth, and geopolitical concerns regarding trade tensions with China and uncertainty surrounding Brexit, among others, appear to be easing, reducing safe-haven flows into the dollar. We believe the jury is still out, however. A turnaround in the dollar’s trajectory will likely require stronger growth outside of the U.S. and signals of tighter monetary policy abroad. That doesn’t appear likely until later this year or beyond. While the Fed has signaled a pause in its rate hikes, it hasn’t ruled out more rate hikes down the road. Emerging-market currencies tend to be particularly sensitive to changes in monetary policy by the Fed, benefiting from Fed easing and being adversely affected by Fed tightening.

Currency values are important for bond investors

For bond investors, the movements of currencies can have significant effects on the rate of return. Investing in foreign bonds can provide important diversification benefits and at times attractive returns. However, even when investing in bonds with higher yields than provided in the U.S., such as emerging-market bonds, the currency return can reduce or even completely offset the return from interest payments and price change.

Price, income and currency returns: Bloomberg Barclays Global Aggregate ex US Index

Source: Bloomberg Barclays. Data as of 2/28/2019. Past performance is no guarantee of future results.

Price, income and currency returns: Bloomberg Barclays EM Local Currency Index

Source: Bloomberg Barclays. Data as of 2/28/2019. Past performance is no guarantee of future results.

Note that since 2010, currency returns have been negative for developed-country bonds in six out of eight years, and five out of eight years for emerging-market bonds.

Neutral for now

We currently hold a neutral view of international developed-country and emerging-market bonds. For the dollar to weaken significantly from current levels, it will likely require a combination of signs that the Fed is poised to ease policy while growth is picking up abroad. We are watching for those signals to appear, possibly later this year. However, for now, the dollar is likely to remain firm.

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