By Joseph Neu
Several factors suggest that the USD is going to finally enter a cycle of structural strength.
“The strongest horse in the glue factory.” “The cleanest dirty shirt.” There are countless euphemisms suggesting that as bad as the US economy is, almost all of the other major economies are trending much worse. Indeed, the relative appeal of the US, along with several other key factors, have certain currency strategists suggesting that a long cycle of relative dollar strength is coming. Indeed, we may be headed back to the early 1980’s when the dollar was truly king.
The next cycle of USD strength
To put a strong-dollar cycle in perspective, it helps to look at the history of the USD against its major trading partners. As the chart below indicates, the USD has had two roughly ten-year cycles in modern times, during which it appreciated sharply for 5 years and then declined to points prior over another 5 years. The periods of sharp appreciation, 1980-1985 and 1996-2001 also correspond with relative US economic strength. And, looking at these cycles, we can see that we may be due for another dollar ramp-up.
What’s more, according to this cyclical view of the dollar, key exchange-rate determinants tend to foreshadow a cycle change. The major ones (relative growth, current account dynamics, rate policy and rate differentials, asset prices and capital flows) all point to an early 80’s-style spike, according to at least one strategist referenced at The NeuGroup’s FX Summit in March. Meanwhile, there is an emerging consensus (or hope) that we are now in the first post-crisis year for financial markets. Therefore, the abrupt risk-on, risk-off price drivers of USD exchange rates and other characteristics of the post-crisis “new normal” will continue to abate, leaving the traditional determinants of exchange rates to prevail.
Post-Crisis Drivers
To help paint a fuller picture of what will drive exchanges rates, Consensus Economics recently published a survey showing the consensus ranking of exchange rate determinants for various currencies (see table below). These weightings can be used to help determine how an aggregate dollar appreciation based on the major drivers might impact specific currency pairs, if you buy that scenario, or more simply what will again tend to drive currencies in these post-crisis years.
Still, as the Consensus Economics report has noted, exchange rates will be influenced by a wide range of factors, which will affect different currencies differently at a given point in time. The recent situation with the Japanese yen, is a good example: a change in government and a change in monetary policy has quickly shifted the exchange rate drivers’ influences.
The Japanese yen example also highlights a policy response to the challenging economic recovery post-crisis: competitive devaluation that may snowball into all-out currency war.
Viewed in this context, too, the dollar may be set to appreciate based on the fact that the Fed has gone so much further sooner than other major central banks to provide liquidity with its QE program. It has little left in its armory to engage in a currency war. As it is poised to pull back, other central banks (in Japan and Europe, in particular) seem ready to throw their previous caution to the wind.
Along with a return to determinant “fundamentals,” relative dollar strength would seem to be a by-product of the on-going currency war, especially, if the increasingly anticipated Fed exit materializes this year.
A tail-risk to contend with
A dollar appreciation of a 1980-85 magnitude (up about 50 percent) would clearly be a game-changer for most US corporates, especially when you consider how much more multinationals rely today on non-US earnings. Thus, whatever probability corporate risk managers assign to a new cycle of dollar strength of significant magnitude, you all have a scenario to consider: how would we relive the early 80s?