Forecasting currency performance is like predicting the outcome of a horse race. Currencies move up the field and then fall back depending on their respective country conditions. And once in a great while, a very strong contender dominates the field – much like the winner of the Triple Crown.
With U.S. growth momentum well ahead of its peers’, the U.S. dollar has lately become the front-runner in the currency sweepstakes. However, we believe the currency Triple Crown will likely prove elusive for the dollar in 2018.
The currency crown
At PIMCO, we monitor exchange rates through a prism of currency valuations, interest rate differentials and business cycle momentum. These seek to provide a holistic view of where each currency is on the racetrack and indeed which ones are likely to move up or fall back in the pack.
It’s rare that any currency has what it takes to win the Triple Crown: namely, superior valuation, highest carry and pre-eminent cyclical position. Triple Crown years are noteworthy because they have typically marked the beginning of multi-year outperformance. In some years, the dollar seems set to win but is only ahead for a “risk-off” stretch as nervous investors seek haven in the dollar.
The dollar won the currency Triple Crown in 1981 and again in 1996 when it was historically cheap, real and nominal interest rates were well above those of its peers, and U.S. growth was outperforming.
It’s tempting to predict that 2018 will deliver another Triple Crown for the dollar: After the dollar’s 7% rise in the past five months, U.S. growth continues to outpace that of other economies and the Federal Reserve is expected to raise the policy rate twice more this year. However, important differences between the present and the halcyon years of 1981 and 1996 bear noting.
Not quite justified
First, in contrast to the Triple Crown years when the real trade-weighted dollar started near all-time lows, the dollar today is not cheap. It is now in the 70th percentile based on valuations over the past 38 years.
Further, equity market valuations also matter, since most cross-border equity flows are not currency-hedged. Based on the Shiller CAPE measure, the valuation of the S&P 500 has been more expensive only 10% of the time since 1980; it is also substantially higher than equity valuations in peer countries by most measures. Unhedged equity investment in the U.S., which helps finance the expanding current account deficit, is thus becoming less attractive.
Finally, while late-cycle fiscal stimulus has kept up cyclical momentum in the U.S. through an unexpected slowdown in much of the developed world thus far in 2018, it is unclear how long that momentum can last. The U.S. faces the risks of not only overheating but also having less scope for fiscal stimulus to fight the next recession. Accordingly, U.S. medium-term bond yields are unlikely to rise much higher than those in peer countries absent a major inflation uptick. This should in turn constrain the dollar’s long-term yield advantage over other currencies.
Looking forward, our expectation is that the dollar will not strengthen a great deal from here, even if a decline is still some way off. We expect other major central banks to begin catching up to the Federal Reserve and to start normalizing interest rates in 2019; we also expect macro uncertainty to remain reasonably contained. This base-case scenario underpins our bias to retain some emerging market currency exposure against the dollar and the euro.
Risks to the outlook
Although the dollar’s odds are long for the Triple Crown, we are closely watching three developments that could potentially keep the dollar at the front of the pack for longer than we currently expect.
- Eurozone growth: So far this year, the major macro surprise has been a surprisingly sharp slowdown in the G10 economies, especially in Europe. If the recovery continues to falter, the European Central Bank is likely to push rate hikes out further, leaving the dollar to continue benefiting from rising U.S. rates, as in 2015−2016. However, after a rise in the currency of another 10% or so, U.S. growth would likely slow due to tighter financial conditions and the fading of fiscal stimulus.
- Trade frictions: If tensions rise sufficiently to threaten global growth and equity market performance, the associated risk aversion will likely favor the dollar as a perceived “safe haven” in the short run, particularly against emerging market currencies. The euro, Japanese yen and Swiss franc should still do reasonably well in this scenario, while currencies of commodity exporters like Australia and Canada will likely suffer.
- U.S. inflation: Perceptions of inflation risk matter tremendously to the fate of the dollar, especially if the market fears the Fed is behind the curve. Inflation risk should work against the dollar relative to most major currencies, but in favor of the dollar against the currencies most sensitive to the global growth cycle, primarily in Asia and Latin America.
For more on our macroeconomic views, please see our Secular Outlook, Rude Awakenings.