Monetary Policy & Inflation | US
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- Market bubbles are bursting, and overvalued markets such as equities and bonds are under pressure.
- However, the dollar is also expensive but has yet to weaken.
- We investigate which currencies the dollar could still have some upside against.
Market bubbles are bursting everywhere. Tech stocks are down 30% this year, while bonds have suffered some of their worst declines in modern history. Clearly, the end of low rates is impacting markets. And it appears both equity valuations and bond returns are returning to earth (Charts 1 and 2). But what about the dollar?
It has been on an uptrend since 2011 and has appreciated almost 50% in real terms. This is more than the dollar uptrend of the second half of the 1990s (Chart 3). The dollar uptrend of the first half of the 1980s saw a larger move, but would only suggest an additional 10% from current levels. Moreover, looking at data going back centuries, we find the dollar is not too far from multi-century highs (Chart 4). So dollar valuations are stretched, and we are nearing historical extremes. The question is, could the dollar bubble burst just like the equity and bond bubbles?
This year has so far seen the opposite, with the dollar surging. Undoubtedly, the Fed pivot to hawkishness, the commodity shock and the recent risk aversion have all helped the dollar. But we must recall that a big reason for dollar strength since 2011 has been the weakness in non-US economies and associated dovish central bank policy. Indeed, ECB was cutting rates on the Euro sovereign crisis , China growth weakness saw a devaluation in 2015, and Japan instituted yield curve control to raise inflation. During this phase, the Fed initially kept policy rates in positive territory and meaningfully raised rates from 2015 onwards unlike the other central banks.
This time, whether the Fed will be the outlier in hiking is unclear. Inflation is global, and it seems untenable that G10 central banks will not exit their negative rate policy stances. Already the Bank of England has started to raise rates, the Riksbank has exited negative rates, and Czech and Polish policy rates are already much higher than the previous cycle. It is even looking like only a matter of time before the ECB starts to hike. This could make it harder for the dollar to have a 1985-style overshoot when US real yields moved higher than the rest of G10.
We therefore prefer to be selective in projecting dollar strength. A starting point would be to see against which currencies the dollar has yet to reach its March 2020 highs. The current outliers would be NOK, AUD, ZAR, BRL, and MXN. These pairs could then still have scope to weaken against the dollar. We also note CNY and GBP have scope to weaken too. Meanwhile, EURUSD is back to its March 2020 lows and USDJPY is in overshoot territory.
But the bigger picture remains, the dollar is near cyclical highs, so we would be cautious in extrapolating dollar strength on a multiyear basis.