Blog

Demystifying the Weak Dollar Puzzle

Market participants have been puzzled by the US dollar’s decline. Expectations over future central bank moves & short-term interest rates offer one explanation.

Market participants have been puzzled by the decline in the U.S. dollar since the November 2016 election. Expectations over future central bank moves and short-term interest rates offer one explanation – and potentially a signal about the dollar’s future.

The dollar has lost ground against the vast majority of major currencies in spite of market optimism about U.S. growth, massive tax cuts, increased fiscal spending and three fed funds rate hikes in 2017 (with more expected in 2018). The rate differentials that currency strategists typically monitor – such as the differential between 10-year U.S. Treasuries and 10-year German Bund yields, or the same differential between two-year rates – failed to signal dollar weakness. In fact, these spreads continued to widen significantly in favor of the U.S. dollar. So what’s behind the weakness?

Some pundits have brushed off the old rhetoric about U.S. twin deficits (that is, an economy with both a current account deficit and a fiscal deficit) prompting the decline. While that thesis may have some merit, there must be far more to the story: After all, some of the strongest dollar bull runs occurred during periods of large twin deficits, such as under Reagan in 1980–1985.

Rate trajectory expectations: a guide to currency moves

A more logical explanation, in our view, is that many market participants had gotten quite convinced that the terminal destination for U.S. short-term interest rates is in the 2.5%–3% neighborhood. As such, every successive Fed policy rate hike became dollar-bearish rather than dollar-bullish as investors concluded that each hike meant we were one step closer to the ultimate destination. (Or, as Robert Louis Stevenson said, “To travel hopefully is a better thing than to arrive.”)

As the chart below shows, the level of the EUR-USD exchange rate since 2016 has closely tracked the differential between expected future Fed hikes and expected future European Central Bank (ECB) hikes.

The same analysis applied to the Japanese yen or the Swiss franc, for example, displays broadly similar patterns, but the fit is less “perfect” than the EUR-USD due to idiosyncratic noise associated with those currencies.

The narrative versus the data

One way to reconcile this data with the twin deficits narrative is to point out that the recent tax reform and fiscal spending package are based on the premise that such policies will ramp up productive capacity to meet the extra demand, while market participants anticipate that the extra demand at a time when the economy appears to be operating at capacity will have to be met by higher imports and stronger economies abroad.

Another alternative explanation may be that a significant rise in inflation acts as the de facto mechanism to ration demand in a capacity-constrained economy. That scenario, in the absence of a change in the Fed’s reaction function, may cause the rate-currency relationship described above to break down, with a rise in medium-term nominal rate expectations not being matched by any discernible dollar strength.

The jury is still out on how this gets resolved, but in the meantime, be on the lookout for movements in the interest rate differential above for clues about the future path of the U.S. dollar.

Enjoyed this article? Subscribe to receive updates to the PIMCO Blog.

SUBSCRIBE
The Author

Mohsen Fahmi

Portfolio Manager, Global Fixed Income

View Profile

Latest Insights

Related

Disclosures

London
PIMCO Europe Ltd
11 Baker Street
London W1U 3AH, England
+44 (0) 20 3640 1000

Dublin
PIMCO Europe GmbH Irish Branch,
PIMCO Global Advisors (Ireland)
Limited
3rd Floor, Harcourt Building 57B Harcourt Street
Dublin D02 F721, Ireland
+353 (0) 1592 2000

Munich
PIMCO Europe GmbH
Seidlstraße 24-24a
80335 Munich, Germany
+49 (0) 89 26209 6000

Milan
PIMCO Europe GmbH - Italy
Corso Matteotti 8
20121 Milan, Italy
+39 02 9475 5400

Zurich
PIMCO (Schweiz) GmbH
Brandschenkestrasse 41
8002 Zurich, Switzerland
Tel: + 41 44 512 49 10

PIMCO Europe Ltd (Company No. 2604517) is authorised and regulated by the Financial Conduct Authority (12 Endeavour Square, London E20 1JN) in the UK. The services provided by PIMCO Europe Ltd are not available to retail investors, who should not rely on this communication but contact their financial adviser. PIMCO Europe GmbH (Company No. 192083, Seidlstr. 24-24a, 80335 Munich, Germany), PIMCO Europe GmbH Italian Branch (Company No. 10005170963), PIMCO Europe GmbH Irish Branch (Company No. 909462), PIMCO Europe GmbH UK Branch (Company No. BR022803) and PIMCO Europe GmbH Spanish Branch (N.I.F. W2765338E) are authorised and regulated by the German Federal Financial Supervisory Authority (BaFin) (Marie- Curie-Str. 24-28, 60439 Frankfurt am Main) in Germany in accordance with Section 32 of the German Banking Act (KWG). The Italian Branch, Irish Branch, UK Branch and Spanish Branch are additionally supervised by: (1) Italian Branch: the Commissione Nazionale per le Società e la Borsa (CONSOB) in accordance with Article 27 of the Italian Consolidated Financial Act; (2) Irish Branch: the Central Bank of Ireland in accordance with Regulation 43 of the European Union (Markets in Financial Instruments) Regulations 2017, as amended; (3) UK Branch: the Financial Conduct Authority; and (4) Spanish Branch: the Comisión Nacional del Mercado de Valores (CNMV) in accordance with obligations stipulated in articles 168 and 203 to 224, as well as obligations contained in Tile V, Section I of the Law on the Securities Market (LSM) and in articles 111, 114 and 117 of Royal Decree 217/2008, respectively. The services provided by PIMCO Europe GmbH are available only to professional clients as defined in Section 67 para. 2 German Securities Trading Act (WpHG). They are not available to individual investors, who should not rely on this communication.| PIMCO (Schweiz) GmbH (registered in Switzerland, Company No. CH-020.4.038.582-2) . The services provided by PIMCO (Schweiz) GmbH are not available to retail investors, who should not rely on this communication but contact their financial adviser.

Macro Matters
XDismiss Next Article
PIMCO