The bull market in the U.S. dollar looks set to extend into 2017 thanks to higher interest rates, increased government spending and potential changes in trade policy.
Look for pullbacks and volatility. The dollar bull market may be in its late stages, but we believe it remains intact.
We continue to favor underweighting international developed market bonds, and the buildup in emerging market corporate debt raises the risks of investing in emerging market bonds.
How long will the bull market in the U.S. dollar keep running? It's worth asking now that the rally looks set to enter its sixth year in the months ahead.
To be sure, the policy mix proposed by the incoming administration of President-elect Donald Trump—expansive fiscal policy, trade tariffs and tax reform combined with tighter monetary policy from the Federal Reserve —is a classic brew for a stronger currency. That should keep the dollar forging ahead in 2017.
But it’s also worth remembering that the risks of the dollar peaking or correcting will rise as the bull market ages. Here we'll look at some of the factors pushing it forward and consider a few those risks.
The dollar ended 2016 at 14-year high and has advanced nearly 42% against a broad basket of currencies from its recent low (hit in April 2011).
Trade-weighted U.S. dollar index: major currencies
Note: The trade-weighted U.S. dollar index is a measure of the value of the dollar relative to other world currencies.
Source: Board of Governors of the Federal Reserve System. The chart shows percent change from year ago, weekly, not seasonally adjusted, monthly data as of 12/23/16.
In terms of length, the current rally is now nearly as old as the two previous two bull markets in recent history—one in the early 1980s and the other in the late 1990s through early 2000s. Each of those lasted between six and seven years. And all three bull markets featured strong demand for U.S. dollars due to relatively high interest rates and expectations of strong investment returns.
Note: U.S. Dollar Index (USDX) is an index (or measure) of the value of the United States dollar relative to a basket of foreign currencies.
Source: Bloomberg, monthly data as 1/3/16. Past performance is no guarantee of future results.
The prospect for further tightening in U.S. monetary policy is one of the major factors behind the dollar’s strength. In fact, most of the dollar’s recent gains came after the Federal Reserve started scaling back its stimulus efforts in mid-2014, with an eye toward eventually raising interest rates. Higher interest rates, when they reflect expectations of stronger growth, make a currency more attractive for investors to hold.
The Fed is one of the few major central banks on course to continue raising short-term interest rates this year. Other major central banks, such as the European Central Bank and Bank of Japan, are still in easing mode. In some cases, they’re actually keeping short-term interest rates in negative territory.
This divergence in monetary policies supports the dollar, especially versus the euro. There is a strong correlation between the euro/dollar’s path and short-term interest rate differentials between the U.S. and Germany, Europe’s largest economy. With two-year government bond yield spreads between the two countries now at their widest level in a decade and poised to widen further as the Fed hikes interest rates, the euro has room to continue weakening against the dollar. Having the euro trade for less than a dollar wouldn’t be out of the question.
High correlation between the U.S./euro exchange rate and the U.S./German two-year spread
Note: This chart shows where the two variables meet. Each dot is a point in time. Daily data shown from 1/2008 to 1/2017.
Source: Bloomberg. EURSUD Spot Exchange Rate and generic government two-year U.S. (USGG2Y) and German (GTDEM2Y) yield difference expressed in basis points. Daily data as of 1/3/17.
Compared to most other major countries, U.S. interest rates are high, which should mean that foreign investors will continue to find U.S. yields attractive. Other factors—trade and current account balances, expectations about investment returns and political trends, to name a few—can also drive changes in currency valuations, but interest rate differentials often form the basis for relative valuations among investors.
U.S. yields far above other G8 yields
Source: Bloomberg. Data as of 1/3/2017.
High hopes for fiscal policy
Hopes that the incoming presidential administration might adopt a more expansive fiscal policy have also pushed the dollar higher. The president-elect has proposed investing $1 trillion in infrastructure over the next 10 years, and both major parties appear to support such spending. Increased spending could boost economic growth by creating more jobs and unleashing more spending in local economies, spurring demand in the short run.
In an optimal scenario, such investments could also improve productivity, lifting the country’s long-term potential economic growth rate. Higher growth would likely mean higher interest rates, providing support for the dollar. That’s the scenario that the market appears to expect.
Trade policy and tax reform
The president-elect has suggested altering U.S. trade policy to protect domestic industry. His policy proposals include labeling China a “currency manipulator,” withdrawing from existing trade agreements and imposing tariffs on imported goods from selected countries. However, not all of these policies are set in stone.
First, designating China a currency manipulator—an official step that could pave the way for punitive tariffs—is a little more complicated than it sounds. To meet the Treasury’s definition, a country must have a significant bilateral trade surplus with the U.S., have a material current account surplus and repeatedly intervene in the foreign exchange market. China doesn’t meet those criteria. Yes, it has a sizable trade surplus with the U.S., but its current account deficit with the outside world is only 2.4%, which isn’t high, and it hasn’t been trying to push its currency lower to gain trade advantage.
While the yuan has fallen by 12% against the dollar over the past two years, China has actually been intervening to support the currency—not to send it lower. China has also altered the basket of currencies it uses to peg the yuan’s value by slightly reducing exposure to the dollar.
Even if the U.S. were to label China a currency manipulator, the impact would likely be delayed since the two sides would have a year to work things out before any penalties kicked in.
Yuan continued to ease against the dollar as 2016 came to a close
Source: Bloomberg. China / U.S. Foreign Exchange Rate. Daily data as of 1/3/2017.
Withdrawing from trade agreements and imposing tariffs on imported goods could be easier. Presidents have fairly wide latitude when it comes to trade. Moreover, tax reform proposals by the Republicans in Congress include provisions for tariffs.
For example, House Republicans have proposed a “border tax adjustment,” which would be used to bring in revenue to fund tax cuts for individuals and domestic companies. A border tax is essentially a tariff by another name. It imposes a fee on imported goods, making them less competitive with domestically produced goods. The tax may also include a subsidy for exports. However, shifting production to the U.S. isn’t always feasible for companies, especially in the short run. Consequently, currency markets could adjust quickly to keep prices of imported goods down by sending the dollar higher.
Risks rising as the bull market ages
While we expect the dollar’s advance to continue in 2017, the risk of a reversal will continue to mount as the rally ages. We can only speculate about what might cause the bull market to end. The economy could underperform expectations, reducing the amount of Fed tightening that is needed. The new administration may have less success getting its fiscal and tax policies enacted. Or deteriorating trade and budget balances could cause foreign capital inflows to slow.
Longer term, major bull markets often lead to overvaluation. Currency bull markets can die at the hands of politicians or of natural causes, or some combination of the two. Sometimes, policy makers try to engineer a devaluation to help boost economic growth or improve trade deficits. In 1985, as the U.S. manufacturing sector struggled with a strong dollar, the Reagan administration negotiated an agreement with Japan and Germany known as the Plaza Accord that allowed the dollar to fall. In the 1990s, the dollar bull market ended with the bursting of the tech bubble, as foreign investors pulled money out of the U.S. economy in favor of more attractive investment opportunities elsewhere.
We continue to suggest investors underweight international developed market bonds due to the unattractive risk/reward balance resulting from a combination of low yields and currency risk. Over the past five years, the dollar’s strength has been a drag on returns from non-U.S. dollar foreign bonds. That could continue this year.
Bloomberg Barclays Global Aggregate ex-US Bond Index
*Currency Return may include paydown return.
Source: Bloomberg Barclays Global Aggregate ex-U.S. Bond Index. Annual data, with 2016 YTD data as of 12/20/2016. Past performance is no guarantee of future results.
Emerging market bonds denominated in local currencies appear vulnerable as well, especially given the large build up in corporate debt over the past five years. U.S. dollar-denominated sovereign debt is likely less vulnerable, but with yields at low levels relative to U.S. Treasuries we would keep a neutral allocation going into 2017.