Is the dollar at a tipping point?

by Sean Tweedie | January 28, 2022

While currency valuations arguably offer little guidance to short and medium-term currency movements, they do offer guidance to the long-term direction of a currency. Over the past few years, the biggest driver in the dollar has been the macroeconomic environment. The dollar bull market between 2011 and 2020 coincided with higher real interest rates in the US relative to the other developed markets. More recently the performance of the US equity markets has further supported the dollar. This month we take a closer look at the dollar valuation and why this will become an important consideration over the next few years.

The framework for understanding the relationship between currencies and the balance of payments (external balance) is relatively simple. Where a country has a rising trade deficit (meaning the value of the country’s imports is greater than the value of their exports), its home currency needs to weaken to boost the competitiveness of its exports or spend less to reduce the trade deficit. Reduced domestic spending is unlikely in most developed economies, given plenty of pent-up demand and loose fiscal policy. Therefore, the natural adjustment mechanism for countries running wide trade deficits will have to be the exchange rate.

The Real Effective Exchange Rate (REER)is an indicator of the external competitiveness of a country’s currency. It is the weighted average of a country’s currency against a basket of other major currencies after adjusting for inflation differentials. When comparing the dollar against a wide range of currencies on a REER basis, we note that the dollar is overvalued. See Figure 1.

Figure 1

Very often these valuations mean little until a trigger point is reached, usually following a significant imbalance. In the US there are signs of these imbalances beginning to appear. For one the US trade deficit continues to deteriorate, with components such as the goods deficit reaching record lows. It is becoming more difficult for the US to finance this trade deficit via the foreign purchase of US Treasuries (such as bills, notes, and bonds). Equity inflows into the US have also started slowing, and so overall the basic balance is deteriorating. See Figure 2.

Figure 2

The US current account deficit (that occurs where a country sends out more money than it receives) for Q3 of 2021 was $214.8 billion, the widest in over a decade. The dollar tends to decline on a multi-year basis when the basic balance peaks and starts deteriorating. See Figure 3.

Figure 3
Currently real interest rates (an interest rate which has been adjusted for inflation) are negative in the US. This is because of both low nominal rates following an accommodative monetary policy and very high inflation. According to economic theory, a currency should adjust to equalize returns across countries. If this holds true, then an overvalued currency should be supported by very positive real returns. Once real returns start to fall, so too should the value of the currency. Currently the dollar is as overvalued as it has been in decades on a simple purchasing power parity (PPP) model basis, while real rates are very negative. At the start of the previous dollar bull market in 2010 the exact opposite configuration was in place, where the dollar was undervalued, and real rates were high. Both in 2010 and today the dollar finds itself to have deviated from the value suggested by economic theory. Currency valuation tends to matter over the longer term, while the macro environment tends to dominate short-term currency trading. Given that the dollar has been over¬valued for the last three to five years, the above analysis suggests we might be at a tipping point where the dollar enters an extended bear market.

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