Dollar Drama: A Fork in the Road

In recent weeks, the “Dixie” (the DXY US dollar index) has reached yet another new 20-year high having risen over 20% from its mid-pandemic January 2021 low. The Euro breached parity in the last week for the first time since 2002.?What do these historic moves mean for US investors with international holdings, and where do we go from here?

Expectations of monetary tightening are driving US Dollar strength

The primary driver of US dollar strength has been the marked change in US monetary policy expectations in response to a rapid and alarming rise in inflation.?A demand shock, a supply shock and excessive monetary growth have conspired to drive prices and wages to levels not seen since 1982. Presently, market expectations anticipate a Fed Funds rate of around 3.5% by early 2023.

While the recent US dollar appreciation is taking all the headlines, this trend goes back to the beginning of 2021. Since then, the?US dollar has risen by over 20% versus the Euro?in the 18+ months to mid-July 2022.

The US Dollar is currently c.30% overvalued vs the Euro; however, its near-term direction is on a knife-edge, dependent upon the Fed and ECB's actions

Given recent currency adjustments, the US dollar’s exchange rate versus the Euro has moved into significantly overvalued territory. While this estimate varies widely depending upon the methodology used, a fair value estimate of around 1.30 to 1.40 appears reasonable, which is c.30%+ higher than the current spot price.?Purchasing Power Parity estimates from the OECD for the JPY cross are close to 100 Yen per US dollar, demonstrating a similar deviation from competitive fair value with the current spot rate over 135.

However, there is a strong case to be made that the US dollar is on a knife-edge and about to encounter a major fork in the road depending on future central policy adjustments by the Federal Reserve and other global central banks.??

The case for a correction

On one hand, the US economy has been overheating, particularly as it relates to the labor market which is tighter than it has been at any time in the last 70 years, with 11.5 million job vacancies and only 6 million unemployed. An examination of the long-term record in the US shows that in economic conditions where inflation is above 4% and the jobless rate is below 5%, a recession has occurred within 24 months in every single instance without exception going back to the 1950s (“A Labor Market View on the Risks of a US Hard Landing,” Alex Domash & Lawrence Summers, April 2022). As such, the probability of the Federal Reserve being able to engineer a soft landing from here is extremely unlikely. If the economy does indeed fall into recession due to the tightening of monetary policy needed to tame inflation, the return on capital in the US will likely decline and the US dollar may well come under pressure.?As such, its recent valuation extremes may mark the end of this 18+-month bull run.?It is notable that after this most recent CPI release, while the front end of the curve sold off indicating the probability of a faster pace of rate rises, the coupon curve flattened as the long end anticipated a higher probability of future recessionary conditions.

But could it rise higher??

On the other hand, however, should the Federal Reserve have difficulty in slowing the economy and continue to raise rates substantially higher than levels currently priced (akin to the prevailing scenario in the early 1980s under?Fed Chair Paul Volker), then even if a recession subsequently occurs, the increase in real rates may be sufficient to drive the US dollar much higher, as was the case from 1981-1985, particularly if foreign central banks lack the seeming resolve of Fed Chair Jerome Powell.?

Furthermore, foreign economies are increasingly concerned that weakness in their currencies against the US dollar may exacerbate inflation pressures by making imports more expensive. There is market speculation of a “reverse currency war” wherein countries seek currency appreciation through policy and intervention tools to address that threat (currency wars have traditionally involved “beggar-thy-neighbour” intentional devaluations to cheapen exports and boost growth; hence, this approach is labelled as “reverse” as it seeks to address inflation rather than growth concerns and so requires the opposite currency movement).

Given the lack of clarity surrounding current inflation dynamics and the unanswered question of whether this inflation is merely cyclical or much more structural in nature, the outlook for the US dollar is as uncertain is it has been in decades.

With more volatility on the horizon, the time to examine your currency exposure is now

The pronounced pickup in currency volatility in 2022 is likely to result in a large impact to returns from currency exposure embedded within international portfolios unless it is managed. Given the probable fork in the road for the USD from here, an active approach to currency risk is likely to be significantly superior to either a fully hedged or unhedged approach, whether the foreign exposure is in equity or fixed income markets.

Data in this article is sourced from Bloomberg and is correct as at 19 July 2022.

The views and opinions expressed in this content are those of?Mark Astley, and do not necessarily represent the opinions of Millennium Global or any of the funds/accounts it manages or any of its Portfolio Managers.

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