Among the questions we are asked most often these days are: Why has the dollar depreciated while the U.S. Federal Reserve (Fed) has been in a tightening cycle since 2015? And will that dollar weakness persist as the Fed continues to hike and deliver interest rates that are among the highest in the developed markets? After all, interest-rate differentials are one of the key determinants of exchange rates.

We think that dollar weakness will continue over the next two to three years. There are a number of reasons why we believe that, but before we discuss them, let us begin by examining the Fed rate-hikes story.

First, there is no iron-clad rule mandating that the dollar must appreciate every time the Fed is in a hiking cycle. Historical evidence clearly shows that the dollar has depreciated during some Fed hiking cycles and appreciated during others. Exhibit 1

It is important to keep in mind these three points:

  1. Exchange rate dynamics, just like any other asset price, are influenced by a host of factors, including economic growth differentials that result in capital flows, current account deficits, and long-term valuations. There is never a single determinant.
  2. Exchange rates represent a relative price. Both domestic and international factors matter for exchange rates.
  3. Markets are forward looking and discount future developments.

How do these three observations help us form our dollar outlook?

Growth Differentials Affect the Dollar

One of the key influences on the dollar has been the unexpected strength of the global economy over the last two years. When growth in the rest of the world gains momentum relative to the United States and growth differentials widen, the dollar is likely to depreciate. There are two main reasons for this:

  • Capital flows to countries where growth and returns on investment are higher.
  • Downturns in the global economy are also periods when global risk aversion rises and the U.S. dollar, which is viewed as a key safe-haven currency, benefits from capital flows.

But as the global economy recovers, these flows reverse and the dollar depreciates. As we have previously discussed, the global economy is now in good shape and the scars of the 2008 global financial crisis have mostly healed. Growth in the rest of the world has picked up relative to the United States. The chart below shows the difference between U.S. growth, 1 and world GDP growth, as calculated by the International Monetary Fund (IMF),  and the relationship to the Real Effective Exchange Rate (REER).2  Exhibit 2

The forecasts suggest strong growth in the rest of the world relative to the United States, hence dollar weakness may continue in coming years. Moreover, while data on global asset managers is hard to come by, we believe that during the U.S. outperformance years, managers likely increased the weight of U.S. assets in their portfolios and reduced the weight of others, such as Eurozone and emerging market assets. We also believe that in the next few years those portfolios will be rebalanced, favoring rest-of-the world assets.

Dollar Cycles Take 5-10 Years

The dollar is coming off of high valuations and typically swings from expensive to cheap. This process historically takes anywhere from 5 to 10 years to complete. The chart below suggests that the current cycle is at its mid-point and the dollar is not cheap yet. Exhibit 3

This pattern can also be explained by economic growth differentials, the normalization of central bank policies, and the forward-looking nature of markets. The U.S. economy’s recovery was better than others after the global financial crisis of 2008. During that same period, Europe suffered from a sovereign debt crisis and a second recession, while emerging markets faced declines in growth, followed by capital outflows that forced a macroeconomic adjustment. The United States was the locomotive pulling the train of global growth during that post-crisis period.

While other major central banks continued to ease monetary policy, the Fed started normalizing policy earlier than others. Markets don’t wait patiently for each Fed rate hike to re-price other assets. When the shift to the hiking cycle starts, markets anticipate it before the first hike actually occurs and assign odds to a future path of interest-rate increases. This in turn helps to determine exchange rates. In our view, the dollar’s appreciation between the summer of 2014 and the end of 2016 (as illustrated in Exhibit 3 above) reflects, in part, the markets’ pricing-in of the U.S. hiking cycle.

Central Bank Policy Shifts Impact the Dollar

What is new since then is the changing policy stance of global central banks. Though lagging the Fed by a few years, other central banks began to signal that the decade-long monetary easing cycle was coming to an end. The European Central Bank (ECB) reduced its pace of asset purchases last year. The market consensus is that such purchases will end in 2018 and the ECB will start hiking rates in 2019. Both the Bank of England and Bank of Canada raised rates in 2017. These shifts in global central bank policies began to influence the dollar.

In our view, the markets are factoring in the policy normalization occurring in the rest of the world, which will strengthen their currencies in turn. We believe this process has started but is not yet done. Developed and emerging market currencies have appreciated since 2016, but only half of the loss in value has been recovered. Exhibit 4

U.S. Facing “Twin Deficits”

Finally, the United States is expected to post large current account and fiscal deficits over the next two to three years. These “twin deficits” mean the U.S. has a savings shortage, with the deficit funded by foreign savings.

Given the recent passage of federal tax cuts, coupled with increased spending by the U.S. government, the Bloomberg consensus for the U.S. federal deficit is close to 5% of GDP, and the current account deficit consensus is over 2% for the next two years. Our expectation is that the twin deficits will be larger than the current consensus. Exhibit 5

This can go on for some time but at some point either the U.S. savings rate needs to rise or the U.S. dollar needs to depreciate to correct for the imbalance. Historically, the dollar begins to adjust and weaken when the twin deficits are in the 6%-8% range.

The timing of the deficits also matters. Typically, budget deficits are larger during the earlier stages of recoveries, when asset valuations are cheaper and attractive for non-U.S. investors. Currently, the cycle is aging, and valuations are not cheap.

In our judgment, all the factors described above add up to a weaker dollar over the next two to three years. Admittedly, there is no perfect exchange rate model and no indicators that are reliably correlated with the dollar. But we believe an improving global economy, capital flows returning to emerging markets, the changing monetary policy stance of global central banks, and twin deficits in the United States all support our call.

We would also note that the path towards a weaker dollar need not be a straight line. If U.S. growth and inflation surprises on the upside, for example, the dollar may appreciate for a short period. As active managers, we always carefully monitor short-term developments, but we believe the factors we have outlined above will likely support our call in the medium-term.

  1. ^This is an imperfect measure for growth in the rest of the world, as the global aggregate includes the U.S. and the weightings of economies change, but the measure is still a good proxy for relative growth rates.
  2. ^The International Monetary Fund defines the Real Effective Change Rate (REER) as “the nominal effective exchange rate (a measure of the value of a currency against a weighted average of several foreign currencies) divided by a price deflator or index of costs.”