First, it’s important to put recent gains in context. The dollar, along with every other asset class, has been volatile over the past five years. More recently, that volatility has abated somewhat as investors have become more comfortable with the Federal Reserve (Fed)’s asset purchase program and inflationary fears have dissipated. Today, the U.S. dollar – based on the U.S. Dollar Index – is roughly where it was in early 2012.
But while the currency has been range bound for the past two years, there are three reasons why I would expect a stronger dollar over the next year:
1. The US economy is improving. As I discussed in a recent post, the economy is firming, and it’s improving at a pace faster than most other developed countries. For 2014 I would expect U.S. growth of 2.5% to 2.75% versus less than 2% for Japan and as little as 1% for Europe.
2. The Fed will be pulling back at a time when many other central banks will need to maintain an ultra-loose monetary policy. By the end of the year, the Fed is likely to have exited its quantitative easing program. In contrast, most other developed market central banks – with the possible exception of the Bank of England – are likely to remain in an easing mode. In particular, the Bank of Japan will continue with its very aggressive asset purchase program for another couple of years. This should lead to a weaker yen.
3. Valuation. Today, based on purchasing power parity, many of the key developed market currencies look expensive relative to the dollar. Based on the Purchasing Power Parity Index compiled by the OECD, the Swiss Franc and the Australian dollar look to be 25% or more overvalued against the dollar, while the Canadian Dollar and British Pound look 10% to 15% overvalued, and the Euro appears roughly 5% above where fair value would suggest it should be. Of the major currencies, the yen looks the cheapest relative to the dollar, but as stated above, it’s still likely to weaken on the back of aggressive easing by the Bank of Japan.
So how is a stronger dollar likely to impact the major asset classes? Historically, a stronger dollar has helped corporations in Europe and Japan, as a weaker domestic currency translates into stronger earnings. This is likely to be particularly true for Japanese companies, which are levered to global trade.
On the flip side, a stronger dollar represents a modest headwind for U.S. profitability and by extension, U.S. earnings growth. Emerging markets, meanwhile, are even more vulnerable. A strong U.S. dollar hurts countries dependent on foreign funding, and as those countries prop up local currencies by selling dollars, this effectively tightens local monetary policy. In particular, I would watch out for countries in Eastern Europe.