It might be seen as nit-picking, but when someone asks for your views on the US Dollar, it is right to respond: “against what?”
More attention is being paid to the Dollar at the moment after recent strength. The rise in bond yields since the election and a likely rate increase from the Federal Reserve are prompting many to rightly question whether this will continue.
The US Dollar is still the world’s reserve currency, and will occasionally be driven by forces that result in correlated strength or weakness against major competitors. This can be seen in the chart below, which shows the DXY index (a measure of the US Dollar against its major competitors), along with some of the familiar stories we tell ourselves about economic history.
Most of the time however, too much emphasis is placed on US dynamics alone, without acknowledging that changes in exchange rates are functions of relative shifts between two regions. Currency spot rate moves are a function of a range of complex forces: interest rate, inflation and growth differentials, shifts in global trade dynamics, and simple speculation.
Even in and around the large moves shown in the chart above, there have been very different dynamics among the four largest components of the DXY (which together make up 92% of the total basket). Sometimes what is going on in the US will be enough to make the Dollar strengthen versus all other currencies, but often this is only part of the story.
Stuart wrote about the risks of focusing on only one leg of a currency pair in 2015 when many were confused as to why the Euro was holding up despite Greek issues dominating the headlines. In that piece he used 1994 as an example, in which rising US rates led many to believe that the Dollar would inevitably appreciate. In fact it weakened versus the Euro (just as it has after the first rate rise in each of the last four tightening cycles).
There are similar elements at play today, with a growing consensus arguing in favour of US Dollar strength but with many of these arguments focusing solely on US domestic issues. Yes, US interest rates look likely to rise rather than fall, but the positive macro surprises have been more pronounced elsewhere.
The factors that drive spot rates will vary between countries but also over time, as structural shifts take place in the nature of an economy. This is why theoretical models for exchange rate determination tend to be weak. In the absence of clear valuation anchors the degree of model uncertainty is high; one factor might explain currency moves in one period but not in another. As a result, and in contrast to the messaging surrounding the boom in internet-based ‘forex trading,’ spot rates are notoriously chaotic.
The good news for investors is that spot rate moves and the returns from currency investing are different things. As well as changes in the exchange rate itself, the investor can earn the difference in interest rate between the two countries involved. Theory suggests that this should be arbitraged but this has frequently, and over the long term, not been the case.
Currency returns over the last twelve months illustrate this phenomenon well. Figure 4 below shows the spot rate returns from holding various currencies versus the US Dollar. Of the seventeen currencies shown roughly half have won and half have lost:
However, if you factor in the impact of interest rate differential the picture changes. A greater number of currencies have generated a positive return versus the US Dollar, with those from Peru, Colombia and India moving from negative returns to quite material positives.
As we have previously discussed, backing currency carry in this way has been shown to work over the very long term, but it comes with a high degree of risk in the short term. Most worryingly for investors, these ‘carry trades’ have periodically displayed a tendency to go against you when equities and other risk assets are also weak.
Investors can therefore use carry as an indicator of which currencies may offer good value, but must supplement this with consideration of all the other factors noted above. Added to this must be an assessment of the prevailing motivation of investors
Even with a rate rise the interest rate buffer in the US is close to zero. Investors should be wary of assuming the inevitability of further generic Dollar strength.