Can the U.S Dollar Keep Appreciating?

The U.S Dollar’s strength has been among the most closely followed stories in the financial news this year. A number of important events and factors have been built into the current level of the Greenback, however arguably the most important would be the U.S Federal Reserve’s monetary policy.

After almost a decade of near zero benchmark interest rates, the U.S Federal Reserve aims to raise their rate by 25 basis points soon. How soon, is the all-important question that plagues the market. But, regardless of when, the market has already begun to impound this information into the price of every Dollar, pushing the value to a new historical high against the Rand and fresh 5 year highs against the Australian Dollar and Canadian Dollar.

However the appreciation of the dollar relative to these currencies is not one-sided. The commodities tumble has hurt the exports of these “commodity-countries” too, making the devaluation more pronounced.

The salient question for Dollar-based investors looking to diversify their investments across all asset classes is: “Will the Dollar keep appreciating?” If the Dollar eventually reverts against emerging market currencies, then their markets should appear relatively attractive as they will yield a two layer return – asset and currency. If it continues to strengthen, emerging market investments will be unattractive and asset-class diversification will continue to be punishable by poor performance.

So, the question needs to be answered. Can a currency continue to appreciate and stabilise, resting at a higher level indefinitely? This question cannot be answered immediately by looking at nominal exchange rates. Instead, one needs to further analyse real exchange rates (RER) to get a sense for the value of one currency relative to another.

A currency is merely a means to an end and to say that the Pound is overvalued relative to the Dollar requires a knowledge of how much that currency can buy you of the foreign country’s goods. If 1 basket of groceries costs you 10 Pounds, and after converting to Dollars and going to the U.S you can buy more than 1 basket of groceries, then the Pound is overvalued relative to the dollar. Standard (and unrealistic!) economic theory posits that a large number of people would convert their Pounds to Dollars and buy their groceries in the foreign country pushing up both the exchange rate and the price levels in the U.S, thereby resulting in an exchange rate that is sensible and in equilibrium.

Clearly there are issues with these assumptions, however we would expect that it would remain largely true over time. And indeed, empirical evidence supports the idea that the real exchange rate has a long-term average to which it reverts. The chart below displays a trade-weighted average of RERs for the U.S and its trading partners, with the horizontal line representing the long-run average. This statistic is called the Real Effective Exchange Rate (REER).

Of course, all of this conjecture can be avoided by simply purchasing a currency-hedged, country specific ETF. However, investors pay for the hedge in the form of reduced performance.
US Historical REER

Source: Bruegel

Now, it is worth mentioning that for the real exchange rate to fluctuate, three variables could conceivably change - price levels in the United States, price levels in foreign countries and nominal exchange rates. As the above chart suggests, the U.S real exchange rate is trending upward. It is by no means obvious when it will revert, but it certainly will over time and for this to happen, price levels either need to increase domestically, decrease in foreign markets and/or the nominal exchange rate needs to weaken.

As an attempt to respond to the question posed earlier – yes, exchange rates could stay at a higher level indefinitely if price levels persist, the freedom to trade a large number of goods is restricted and central banks artificially interfere with the money supplies or raise/lower interest rates.

Our view is that the U.S effective exchange rate will steadily depreciate, however it is not clear how long this process will take, with some research indicating that REER deviations/reversions take years. As mentioned above, for the REER to depreciate, relative price levels need to increase and/or nominal exchange rates must depreciate. Considering the period of very low inflation that the developed world is experiencing, the only variable with considerable wiggle room is the nominal exchange rate. Furthermore, it is also not clear which currency the Dollar will weaken against as this measure of real exchange rates is based on a trade-weighted basket of currencies.