Long term outlook for the US dollar

The US dollar is arguably somewhat overvalued, but this could only limit   the extent of US dollar strength.

>> US dollar could rally for safe-asset reasons

Not just the next year, or so, but the next five or ten years? In the past, we’ve tended to see a modest bias towards a weaker US dollar but it seems that the scope for weakness is being squeezed all the time.

Perhaps the place to start is to look at how the US dollar has moved up to now, why it has moved as it has, and whether these factors are changing and still relevant for the future. On the US dollar’s performance to date, if we start with floating rates in the 1970s we see that the US dollar has outperformed other major currencies such as the euro (and its forerunners), the pound and the yen.

In fact, a look at the US dollar’s real effective exchange rate since 1975 shows that currencies have performed in this order: the US dollar is around 15% higher than the mid-1970s, the euro 5% higher, the pound about 17% lower and the yen almost 20% lower.

Of course, there’s been huge variation over this period with bouts of significant US dollar weakness and strength but, in general, it is fair to say that the dollar has appreciated. And it has appreciated in spite of the huge accumulation of external debt. At the same time, the country accumulating large external surpluses, Japan, has seen its currency weaken the most. So, what factors can explain why the US dollar has been able to rise in spite of such external indebtedness?

Mr. Steve Barrow, Head of the Standard Bank G10 Strategy, said the first is that the US dollar’s dominant position in global financial markets – or the US’s exorbitant privilege as it is sometimes called – appears to have made the dollar impervious to the accumulation of large overseas debts and may have even been a source of strength, especially when disaster strikes the world, like the global financial crisis or the pandemic.

Another factor is that the US has generally offered larger returns than other countries, whether this be in terms of interest rates or stock market performance. Of course, such an advantage is ‘required’ in order to suck in the foreign savings needed to fund large deficits, but there’s a sense that the US probably receives more than it needs, which reflects the infamous “global savings glut” idea espoused by former Fed Chair Bernanke.

>> US dollar is still struggling to rally

On top of these ‘structural’ supports for the dollar there seem to be cyclical factors right now such as the rate hike cycle of recent years, the adverse terms of trade shock for Europe, Japan and many others that resulted from the surge in gas prices as Russia launched its attack on Ukraine; something that has helped the US achieve an enhanced degree of so-called exceptionalism right now.

“In the not too distant future these cyclical supports will fade; indeed, the adverse terms of trade shock has already turned as gas prices have plummeted. But as the global monetary cycle starts to ease and other countries in the G10 region close the growth gap with the US, so we might expect the dollar to lose some of its strength. That’s why our forecasts over the next year, or so, see the euro up to the 1.20 region, or 130 for the yen”, Mr. Steve Barrow said.

However, what after that; after these cyclical effects have washed through? Mr. Steve Barrow said that the structural factors supporting the US dollar would  remain in place; they might even get stronger. Europe, for instance, could be hampered by the need for higher military spending, especially if Russia prevails in Ukraine. He also sensed that the US could be embedding a significant productivity advantage from its more stimulative fiscal policy and its greater willingness to respond to bank pressure for softer regulation.

Should this productivity/growth advantage not just persist, but potentially increase, it is likely to ensure that returns in the US in terms of both interest rate levels and equity market performance will be more than sufficient to attract the levels of foreign savings required to fund external imbalances. Of course, there are risks with the US dollar’s global dominance often cited as a source of longer-term vulnerability, but Mr. Steve Barrow doesn’t share this view. “The US dollar is arguably somewhat overvalued (by around 9% in 2022 on the IMF’s measure) but we see this as more likely to limit   the extent of dollar strength than pushing the greenback into a longer-term structural bear trend”, Mr. Steve Barrow forecasted.