The story of the U.S. dollar so far this year has two sides. The greenback has gained against most developed market (DM) peers, but depreciated against emerging market (EM) currencies so far this year. We see this trend as likely to run on in the short term in the absence of policy surprises.
The dollar’s strength among DM currencies this year has come as a surprise to some. A combination of rising risk appetite, slowing U.S. growth and a Federal Reserve taking a pause in its monetary tightening would typically weigh on the greenback. Yet the same factors keeping the Fed on hold–slowing global growth and tightening financial conditions–are pushing other central banks toward a more dovish stance. This has helped the dollar retain its status as the highest-yielding DM currency, as the chart shows. Yet currency yield differentials–a measure of interest rate differentials–are not the only driver of currencies. The British pound’s fate is linked more to Brexit developments. And rising oil prices and risk appetite have helped the Canadian dollar’s performance so far this year.
What does a stable dollar mean?
The dollar’s yield advantage–the highest since early 2018 against a trade-weighted basket of G10 currencies–has led to a revival of the “carry trade.” Investors are borrowing in lower-yielding currencies such as the euro or Japanese yen, investing in higher yielders like the dollar and EM currencies, and pocketing the difference in yield (some of that “carry” is lost for investors hedging their dollar exposure). We see this trend as a key driver of currency movements in the short run–as the Fed appears likely to hold off on rate increases at least through the first half of the year, and other DM central banks are also expected to stay dovish.
A more stable dollar, coupled with a slowing but still growing global economy, underpins our positive view on EM assets. For one, it removes a key risk for emerging market economies with large external debt burdens. As many EM debtors borrow in dollars, a stronger greenback raises their borrowing costs – and tightens EM financial conditions. A more stable dollar also reduces the danger of taking on EM currency exposure, historically a large source of volatility for investors in local-currency EM debt. This underlies our recent call for a balanced approach to EMD, taking risk in both local- and hard-currency debt. We see both as attractive sources of income and are overweight EM equities. EM assets in general tend to perform well when EM currencies are rising. Risks to our positive EM views: an earlier-than-expected resumption of Fed tightening and the renewed dollar strength that would follow suit.
We see the dollar holding its gains against most DM peers and under-performing EM currencies in the short term. Uncertainties in global growth and geopolitics cloud the longer-term picture. The dollar’s perceived “safe haven” role is likely to boost the greenback in the event of any return of recession fears or a resurgence in geopolitical risk. The dollar’s relatively high valuation may limit its upside in the long term. The real effective exchange rate–a key trade-weighted gauge of the dollar’s value – is sitting roughly one standard deviation above the 20-year average.