Since mid-April, the U.S. dollar has appreciated by about 6% relative to a broad basket of currencies. What is behind this sharp move and will it continue?
After weakening significantly during 2017, the U.S. dollar (USD) has found a bid in recent weeks. This move has caught many by surprise. In fact, aggregate speculative positions by short-term investors in mid-April suggested that shorting the dollar was a very popular trade. At stretched levels, this tends to be a contrarian indicator. Heavy short positioning is one key reason behind the dollar’s rebound as traders likely scrambled to minimize their losses.
Another key driver of dollar strength has been more confidence by market participants that the Federal Reserve (Fed) will be able to raise rates three or four times this year due to an improved growth and inflation outlook in the U.S. This factor, combined with weaker growth figures outside of the U.S. (particularly in Europe) in the first quarter, helped to push the dollar higher.
Elevated political risk in Europe (particularly in Italy, but also in Spain) resulted in the dollar reaching still higher levels toward the end of May due to its traditional status as a “safe haven.”
Now that we’ve identified a few main factors behind the dollar’s march higher, what is our outlook going forward?
In the medium-to-long term, the dollar faces pressure from the risk of “twin deficits,” meaning a deficit in both the budget balance and current account balance. Historically, there has been a modest inverse correlation between the strength of the U.S. trade-weighted dollar and the size of the “twin deficits” (though different periods vary widely).
As we’ve written previously, fiscal stimulus is rarely enacted at this point (mid-to-late) in the cycle. While the fiscal stimulus may be supportive of the dollar in the short term, in the long term, U.S. assets may be deemed as higher risk due to greater concern about the sustainability of U.S. debt.
Finally, from a valuation perspective, the dollar appears to be modestly expensive relative to its fair value on a historical basis.
Overall, we have a relatively neutral view on the U.S. dollar over the medium term. We feel that the factors driving the dollar higher in recent weeks have largely been priced in (e.g., the Fed outlook) or were more temporary in nature (e.g., stretched investor positioning, weaker economic data outside the U.S.). Additionally, we see longer-term risks to the dollar from an expected widening of the U.S. budget deficit and current account deficit.
The U.S. dollar index is a measure of the value of the U.S. dollar relative to the value of a basket of currencies of the majority of the U.S.’s most significant trading partners.
The Trade Weighted U.S. Dollar Index is a weighted average of the foreign exchange value of the U.S. dollar against the currencies of a broad group of major U.S. trading partners.