Have you ever wondered why global markets have been so calm since the volatile first quarter? Well, the halt in the U.S. dollar’s appreciation played a major role: It helped stabilize commodity prices, end the U.S. manufacturing recession and soothe fears about both aggressive Chinese currency depreciation and excessive dollar debt in emerging markets (EM).
However, during October the dollar rallied by 3% against other developed market (DM) currencies, as measured by the dollar index (DXY). Given the damage done by the (albeit much, much larger) dollar appreciation in 2014–2015, it’s worth considering how likely it is that the dollar will rise significantly from here.
For starters, consider why the dollar strengthened recently: A rising likelihood of more divergent global monetary policy has played an important role. Markets are now pricing in a 75% chance of a 25 basis point Fed rate hike in December, up from about 50% around the time of the September Fed meeting. Meanwhile, European Central Bank (ECB) President Mario Draghi recently reassured markets that an early end of quantitative easing (QE) is not in the cards. And in Japan, while a further easing of monetary policy seems unlikely to us, the fact that the Bank of Japan keeps 10-year government bond yields more or less anchored at the 0% target while rates elsewhere have been rising has contributed to a weakening of the yen.
Memories of 2014–2015 are still fresh
However, we do not expect the dollar’s rally to gain much steam from here. The memories of the 2014–2015 strong dollar episode are still very much alive among policymakers and will likely limit the appetite for excessive monetary policy divergence and competitive currency depreciation. In other words, what I have called the “Shanghai co-op” – a mutual understanding of all relevant parties involved in the February 2016 G-20 meeting that excessive dollar strength was bad for everyone – appears still to be very much in place.
In practice, this means that the Fed will aim (again) at making the December rate hike the most dovish in history by emphasizing that the future rate path will be very shallow. Janet Yellen’s “high-pressure economy” comment is likely to prompt further discussion in future Fed communications. In turn, the Bank of Japan and the ECB will likely continue to refrain from cutting rates further into negative territory and will rather keep focusing on domestic easing.
One motivation for de-emphasizing monetary policy divergence is that excessive dollar strength would encourage a more aggressive depreciation of the Chinese yuan against the dollar, given the Chinese authorities’ desire to prevent yuan appreciation vis-à-vis the broad currency basket they are targeting. Trade-weighted depreciation or broad stability seem fine in their view, but appreciation is not. Another motivation is that excessive dollar strength would harm EM dollar debtors and commodity prices – and could thus undermine the recovery in the commodity complex in EM and within the U.S.
Valuations also argue against a further strong appreciation: Compared with when the big 2014–2015 dollar rally started, the greenback is no longer undervalued. Europe’s and Japan’s structural current account surpluses lend fundamental support to the euro and the yen, and the European banks’ woes curtail the sector’s ability and willingness to recycle the eurozone’s savings surplus (and particularly Germany’s 8% of GDP) into foreign assets. This leads to structural upward pressure on the euro that is only just being neutralized by easy ECB monetary policy.
All told, we expect the dollar to remain in a broad “Shanghai co-op” range versus the euro and yen despite its recent appreciation, because this is what is in the interest of all the relevant actors following the 2014–2015 experience. If so, we think being long a diversified basket of high-carry EM currencies against the dollar continues to makes sense.
Joachim Fels is PIMCO’s global economic advisor and a regular contributor to the PIMCO blog.