Investors holding foreign assets with exposure to the U.S. dollar have had a volatile ride year to date: up in Q1, down in Q2, and back up in Q3. Now that the dollar is near the year's highs, can the rally continue? We believe it can in the near term, although our longer-term view is more nuanced. Here's what we see ahead.
Multiple factors support dollar strength in the near term
Although the dollar is near its year-to-date high, it is likely to get support over the next year from relatively high U.S. interest rates--at least, compared with those of other major developed countries--expectations for tighter Federal Reserve policy, and the slowing in global growth.
The dollar is just below this year's high
Shows U.S. Federal Reserve Trade-Weighted Nominal Dollar Index (USTWBGD Index), a measure of the value of the U.S. dollar relative to other global currencies. Daily data as of 8/27/2021. Past performance is no guarantee of future results.
1. U.S. interest rates are high relative to global rates
So far during 2021, the dollar's strength has been driven largely by the rise in U.S. interest rates relative to those in other major developed countries. Although U.S. yields are low in real terms—that is, adjusted for inflation—that hasn't been enough to push the dollar lower. It appears that the market is viewing the recent inflation spike as transitory. Moreover, in the yield-starved world of government bonds, even the paltry yields on U.S. Treasuries look attractive.
U.S. yields are above other major developed-country yields
Source: Bloomberg. Data as of 8/26/2021.
Past performance is no guarantee of future results.
We compared the 10-year U.S. government bond yield to the average 10-year government bond yield in major developed markets. Barring dollar liquidity crises, the interest rate differential has had a strong relationship with the direction of the dollar--typically rising and falling in tandem. The interest rate differential is currently providing support for a stronger dollar, as it is above 1% and increasing.
Interest rate differentials historically drive the direction of the dollar
The 10-year interest rate differential compares the U.S. government bond yields with those of Germany, Canada, Japan, the U.K., Switzerland, Australia and Sweden. U.S. Federal Reserve Trade-Weighted Nominal Dollar Index (USTWBGD Index).
Past performance is no guarantee of future results.
2. Global central bank policies should support the dollar
The dollar moved higher over the summer as markets expected the Fed to begin tapering its asset purchases in the months ahead. In a speech at the Fed's annual Economic Policy Symposium in Jackson Hole, Wyo., in August, Fed Chair Jerome Powell prepped the markets for a tapering announcement later this year--but the dollar dropped on indications that Fed rate hikes might not follow the end of its quantitative-easing program as quickly as expected.
However, with the Fed's policy rate higher than the currently negative policy rates of the Bank of Japan (BOJ) and the European Central Bank (ECB), support for the dollar should remain intact for the near term. The bottom line: Once tapering is complete in 2022, as is currently expected, the Fed will have more flexibility to raise short-term rates based on the outlook for inflation and the labor market. By comparison, other major central banks appear likely to maintain easy policies.
The Fed's policy rate is above those of other major central banks
Data reflects the Fed's federal funds rate upper target, the BOE official bank rate, the BOJ policy rate balance rate, and the ECB deposit facility announcement rate. Data as of 8/30/2021.
3. Declining global growth prospects may weigh on emerging-market (EM) currencies
The dollar has moved up relative to EM currencies on signs that the pace of global growth is slowing. China's regulatory and credit policies have rippled through Asian EM countries. The decline in credit growth and increased regulatory control of some industries have led to slower economic growth and contributed to a drop in commodity prices. China's credit impulse tracks the growth rate of credit in China--as of July, the year-over-year growth rate in credit was -5.29%. The decline is likely to weigh on the Chinese yuan (CNY) relative to the U.S. dollar.
China's new-credit growth rate has slowed
Source: Bloomberg, Bloomberg Economics China Credit Impulse 12-Month Net Change (CHBGREVA Index).
The credit impulse is the change in new credit issued as a proportion of gross domestic product. Monthly data as of July 2021.
Given that China is a top trading partner of the U.S., it is the second-highest currency weight in the Fed's trade-weighted dollar index. This means a weaker CNY translates to a stronger trade-weighted dollar.
China is the second-largest weight in the Fed trade-weighted dollar index
Source: Federal Reserve.
Federal Reserve's Broad Trade-Weighted Dollar. Data as of 2021.
The decline in China's growth also affects emerging-market economies that export commodities to China. Lower commodity purchases translate to lower commodity prices, keeping emerging-market currencies down and the U.S. dollar up.
Over the longer term, the dollar faces some risk
Looking out two to five years, we are less positive. The large budget and current account--or trade--deficits and the prospects for a broader global recovery should put downward pressure on the dollar over the long run.
Widening current account deficits tend to lead to a weaker dollar in the long run
Federal Reserve trade-weighted dollar index and the U.S. current account balance as a percentage of gross domestic product (GDP) (USTWBGD Index, EHCAUS Index). Quarterly data as of March 2021. Past performance is no guarantee of future results.
We will be watching yields and portfolio flows for signs that investors are shifting away from dollar-denominated assets in favor of other currencies. If this occurs, the decline in the dollar would provide a boost to international investments. When that time comes, we will change our view accordingly. In the meantime, the dollar is likely to head higher.
What to consider now
We expect the dollar to strengthen moderately over the coming months. A stronger dollar is generally negative for commodity prices and reduces returns on international investments. We are maintaining a neutral view for emerging-market and global (non-USD-denominated) bonds. Whenever yields are at such low, if not negative, levels in the global bond market, performance of the broader index tends to track more closely to the movement in the dollar. The stronger dollar year to date has weighed on the global bond market.
The stronger dollar has led to lackluster returns for global bonds
Bloomberg Barclays Global Aggregate ex-USD Bond Index (LG38TRUU Index). Daily data as of 8/27/2021. Past performance is no guarantee of future results.
To be clear, our neutral outlook for international fixed income is not an underweight--it is still important to have exposure to international fixed income to provide diversification to a bond portfolio. We also suggest:
- Maintain a below-benchmark duration in global bonds (ex-U.S.). It is crucial to keep in mind that the duration, or price sensitivity to rate changes, of global bonds is higher than the broad U.S. aggregate bond index. Be cautious about how much duration is added to the portfolio from the global bond holdings.
- Look for opportunities to rebalance to the target weight for international fixed income. It is likely that international bonds haven't kept pace with other fixed income investments this year, leading investors to be underweight. Try to pick up international fixed income bonds at a cheaper price when the spreads over Treasuries rise.
- Keep expectations in check. The main reason for maintaining a neutral weight to international fixed income is to keep a more diversified bond portfolio and prevent timing the market. As such, international fixed income is unlikely to be the "breadwinner" for your portfolio anytime soon.
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