2017-5-3
Is the dollar going to weaken? - Adviser - Schroders
ECONOMICS
TalkingEconomics: Has the dollar
turned?
Amid signs that the US dollar is dragging on US activity we believe that the path is open to a
weaker currency. President Donald Trump would welcome dollar depreciation as would the
emerging markets, but such a development could be problematic for the European Central
Bank (ECB) and Bank of Japan (BoJ).
03 MAY 2017
Keith Wade
Chief Economist & Strategist
30 Minutes Unstructured
Learning
Time
In a break from tradition, Donald Trump has started to call for a weaker dollar,
reversing the convention that the president always supports a strong currency.
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2017-5-3
Is the dollar going to weaken? - Adviser - Schroders
Although the president’s ability to influence the dollar is limited, there is a case to be
made for a reversal of dollar strength. Since the currency’s sharp appreciation, the
trade sector has weighed on economic growth.
Outlook: weaker dollar potentially on the cards
The US dollar has been buoyed by the tightening of US monetary policy at a time when
central banks elsewhere are keeping policy loose. However, the relationship between
rates and currencies is not straightforward. Currencies tend to move ahead of interest
rates as investors adjust their expected returns.
When interest rates move against a currency its value must fall to the point where it
offers sufficient potential for appreciation so as to restore equilibrium. This is the basis
for “overshooting” where a currency will move significantly ahead of rate changes, but
will subsequently stabilise or appreciate when those moves materialise.
This ties in with previous tightening cycles by the Federal Reserve (Fed) where, instead
of seeing the dollar rise alongside higher US interest rates, the picture is more mixed.
Our analysis of eight previous cycles shows that on average the dollar tends to be
slightly weaker to flat after the Fed starts to raise rates.
Something similar appears to be happening today: the dollar rose sharply ahead of the
Fed beginning to tighten monetary policy but is now falling back, having overshot its
long-run value.
Forecasting currencies is notoriously difficult, but it could well be that the president will
get his wish and we now see a weaker rather than stronger dollar going forward as the
overshoot unwinds.
Some implications
The end of dollar strength would remove a deflationary factor for the US economy.
Import prices would rise more rapidly, adding to inflation.
However, it could add to deflationary forces in Europe and Japan, creating potential
problems for the ECB and BoJ. Investors in these countries would also need to be wary
of moves in the euro and Japanese yen if there were a significant move in the dollar,
given the negative correlation these currencies have with their respective equity
markets.
For the emerging markets, an end to dollar strength would come as a relief, easing
concerns about the effects of tighter monetary conditions in the US being transmitted
to emerging economies via dollar borrowing.
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2017-5-3
Is the dollar going to weaken? - Adviser - Schroders
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