Who’s afraid of the big bad dollar?
For most of the past two years, the dollar had a ferocious run.
Compared to the currencies of its major trading partners, the dollar strengthened by 27% from the start of 2021 through September 2022. For the first time ever, a pound bought less than $1.04 and the dollar’s strength extended beyond its traditional peers – it has also hit a record high against the Chinese renminbi, and strengthened even against the currencies of commodity-rich countries like Norway.
It is easy to see why. Higher interest rates attract investors, who must first buy the currency to buy high-yielding assets priced in that currency. Over 2022, the gap between interest rates in the US and elsewhere rose dramatically as the Federal Reserve belatedly woke up to the risk of persistent inflation and raised rates from zero to 4.5%. Other central banks have not hiked rates as quickly, so the so-called “rate differential” between the US and other countries widened. That made dollar assets more attractive to investors, boosting demand for dollars at the expense of other currencies.
US GDP rises higher than expectations
The dollar has other strengths. The US economy has looked stronger than most others, and as the global reserve currency, the dollar benefits as a “safe haven” when investors are fearful about other assets.
Crucially, the US also produces plenty of its own energy, at a time when Russia’s invasion of Ukraine led to skyrocketing prices. That hurt the so-called “current account” balance of commodity importers, who had to spend more of their own currency buying commodities. Diverting money towards energy also drained money from other parts of their economies, increasing the risk of a recession.
To cushion the blow to households and industry, governments in continental Europe, the UK, and Japan unveiled a raft of energy subsidies. These have the benefit of reducing reported inflation, but they are costly, leading to unusually large fiscal deficits. Widening deficits do not a strong currency make.
To the dollar’s strength, other major currencies added their own weaknesses. The eurozone has been most dependent on Russian gas, struggles to reach consensus on how to address energy shortages, and faces political uncertainty from far-right governments, most recently in Italy.
The Bank of Japan, unique among its peers, refuses to raise interest rates or abandon its cap on long-term bond yields. Instead, it has turned to direct currency intervention for the first time since 1998. As long as bond yields remain suppressed, that should be about as successful as ice skating uphill. A tweak to their yield curve policy in December showed the first clear cracks in their strategy.
The Bank of England also intervened (in the bond market), after the tax-cutting Mini Budget from Liz Truss’s lettuce-bested government sent the pound to a record low and gilt yields to 15-year highs.
Will the strong dollar continue to spook markets?
All that calls to mind a 2016 Economist cover of a greenish George Washington with the biceps of Arnold Schwarzenegger. But we’re also mindful of a different cover, from late 2020, showing a terrified Benjamin Franklin watching nervously as inflation caterpillars chew through his $100 bill.
The US may have an inflation problem. But, the most important case against the dollar, and the key reason we remain so underweight, is its valuation. Intuitively, if a shopping basket costs $120 in the US and £100 in the UK, one pound should buy $1.20. Currency cycles are long and noisy, but in time, exchange rates show a strong tendency to revert towards purchasing power parity. On that basis, the US is still expensive against every tradable currency we track. Our models suggest the dollar is overvalued by 22% against the euro, by 26% against the pound, and by a whopping 55% against the yen.
That quantitative metric is only our starting point – it is important to analyse the buyers and sellers of a currency and how they could change over time. But when a currency is more than 20% overvalued, it suggests to us that it may be a poor store of purchasing power. This is largely why we actively manage our currency exposures.
It is hard to imagine now, with everything going right for the dollar, that anything could shake its strength. But things will change. They always do.
As contrarian investors we know that the path from “completely terrible” to “merely bad” can be extremely rewarding. The same is true in the other direction. The path from “completely perfect” to “merely excellent” can be an extremely painful one. With currency valuations where they are, that is a great risk for the dollar, and a risk worth mitigating.
Alec Cutler is portfolio manager of Orbis Global Balanced
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