Market participants have been puzzled by the decline in the U.S. dollar since the November 2016 election. Expectations over future central bank moves and short-term interest rates offer one explanation – and potentially a signal about the dollar’s future.
The dollar has lost ground against the vast majority of major currencies in spite of market optimism about U.S. growth, massive tax cuts, increased fiscal spending and three fed funds rate hikes in 2017 (with more expected in 2018). The rate differentials that currency strategists typically monitor – such as the differential between 10-year U.S. Treasuries and 10-year German Bund yields, or the same differential between two-year rates – failed to signal dollar weakness. In fact, these spreads continued to widen significantly in favor of the U.S. dollar. So what’s behind the weakness?
Some pundits have brushed off the old rhetoric about U.S. twin deficits (that is, an economy with both a current account deficit and a fiscal deficit) prompting the decline. While that thesis may have some merit, there must be far more to the story: After all, some of the strongest dollar bull runs occurred during periods of large twin deficits, such as under Reagan in 1980–1985.
Rate trajectory expectations: a guide to currency moves
A more logical explanation, in our view, is that many market participants had gotten quite convinced that the terminal destination for U.S. short-term interest rates is in the 2.5%–3% neighborhood. As such, every successive Fed policy rate hike became dollar-bearish rather than dollar-bullish as investors concluded that each hike meant we were one step closer to the ultimate destination. (Or, as Robert Louis Stevenson said, “To travel hopefully is a better thing than to arrive.”)
As the chart below shows, the level of the EUR-USD exchange rate since 2016 has closely tracked the differential between expected future Fed hikes and expected future European Central Bank (ECB) hikes.
The same analysis applied to the Japanese yen or the Swiss franc, for example, displays broadly similar patterns, but the fit is less “perfect” than the EUR-USD due to idiosyncratic noise associated with those currencies.
The narrative versus the data
One way to reconcile this data with the twin deficits narrative is to point out that the recent tax reform and fiscal spending package are based on the premise that such policies will ramp up productive capacity to meet the extra demand, while market participants anticipate that the extra demand at a time when the economy appears to be operating at capacity will have to be met by higher imports and stronger economies abroad.
Another alternative explanation may be that a significant rise in inflation acts as the de facto mechanism to ration demand in a capacity-constrained economy. That scenario, in the absence of a change in the Fed’s reaction function, may cause the rate-currency relationship described above to break down, with a rise in medium-term nominal rate expectations not being matched by any discernible dollar strength.
The jury is still out on how this gets resolved, but in the meantime, be on the lookout for movements in the interest rate differential above for clues about the future path of the U.S. dollar.
For in-depth insights into our views on currencies, equities, bonds and other asset classes in 2018, please read the 2018 Asset Allocation Outlook, “Singles and Doubles.”
Mohsen Fahmi is a generalist portfolio manager focusing on global fixed income and a member of PIMCO’s Investment Committee.