Market Views: Will the dollar suffer prolonged weakness?

Since the beginning of 2018, the US Dollar Index, which measures the value of the dollar against a basket of six developed market currencies, has dropped by around 3%, after falling by around 10% in 2017.

This has taken place in an environment of rising rates, with the Fed raising interest rates three times in 2017, as well as robust growth in the US economy. The S&P 500 increased by around 17% last year and the MSCI USA index saw 21.9% returns in the same time period.

Some of the weakness can be attributed to an improving European economy, which has strengthened the euro relative to the dollar, as well as political uncertainty surrounding the current US administration.

In 2018, with increasing US protectionism, including tariffs on washing machines, solar panels, steel, and aluminium imports either implemented or announced this year, as well as the prospect of other central banks moving towards policy normalisation, the dollar may face even more downward pressures.

We asked three market observers whether the dollar would continue to weaken in 2018.

Moh Siong Sim, currency strategist

Bank of Singapore

Our view is that the US dollar weakness is likely to be protracted. For the euro, our year-end focus is $1.29.

The reason why I think there's more dollar weakness to come is for a few reasons. One is that I think in the past there has been a dominant focus on the Fed. The Fed (US Federal Reserve) was of course was the first to start the monetary tightening, meaning rate hikes, and also the first to taper the QE (quantitative easing), and now we are moving in a stage of quantitative tightening.

But since last year, the Fed is no longer the only game in town. Since late last year, we all know that the ECB (European Central Bank) has announced and implemented plans to taper the QE. It's not just the ECB, but also the Bank of Japan, where there is increasing discussion as to whether the Bank of Japan could move towards policy normalisation as well by tinkering with its yield curve control possibly later this year.

The second reason why the dollar may stay weak is related to the concerns about twin deficits in the US. The US runs a current account deficit, but on top of that the fiscal deficit is likely to increase as well, given the extent of fiscal stimulus announced by the Trump administration recently. Historically, whenever, there are concerns about twin deficits, it tends to be a drag on the US dollar, and I think this time around, it will not be too different, and that's going to weigh on the US dollar over the medium term.

The somewhat hawkish rhetoric from (new Fed chair) Jerome Powell may result in a temporary bounce in the US dollar, but I don't think it changes the medium term outlook for the US dollar in terms of further weakness over the next 6 to 12 months. We could see a bit of temporary rebound in the dollar itself, but the downtrend is likely to stay intact.

For Asian investors, if they have been investing globally in US dollar assets, in the past they have been happy to leave it unhedged, but increasingly, if the dollar is going to weaken and you invest in dollar assets, then your return from these dollar assets once you cash out is likely to be undercut by dollar weakness. That means that Asian investors need to pay much more attention in terms of managing the currency risk. The return in their own currency may be much lower than what they had enjoyed in the past.

The typical ways to hedge currency risk would be through forwards. They can use various instruments to hedge the currency risk, but they are locking in the rate at the initial stage so that they don't suffer currency losses if the dollar weakens.

Sven Schubert, specialist investment strategy currencies and emerging markets

Vontobel Asset Management

Structural factors do argue for a continued downtrend of the dollar. the euro/US dollar exchange rate may see [the dollar's value fall to] $1.40 in 2019.

Beyond our outlook for a short term dollar bounce, we remain convinced that the dollar is still in a downward trend. Firstly the monetary normalisation process in the US is well underway and in several other parts of the world (Japan, European Monetary Union, etc.) has not even started, or is in the very early stage. The 10 year government bond yield spread between the US and Germany is still at a multi-decade high. Spreads are likely to narrow, undermining the US dollar further.  Fed Chairman Powell’s recent testimony was upbeat on US growth but is unlikely to change the broad trend of narrowing.

Furthermore, even though it is too early to judge about the sustainability of the US fiscal policy, we do observe increasing signs of fiscal slippage in the US, as it seems that the budget deficit will rise to 5% of GDP. It remains to be seen whether the announced tax cuts will deliver investment and therefore productivity growth.

If not, buyers of US treasuries may require a higher compensation for holding US treasuries, which would probably slow the economy without supporting the dollar. Finally central banks’ reserve managers are probably moving away from the US dollar (63% share) over time.

With the European political risk slowly fading the euro share may increase again after a reduction from 28% to 20% following the great financial crisis. As China is liberalising its financial markets, its share in central banks reserves is likely to rise from its current share of 1%.

Investors should run a moderate underweight of the US dollar and give more exposure to European currencies. Any euro/US dollar correction to levels below $1.20 should be used to increase the euro exposure.

Erik Weisman, chief economist

MFS Investment Management

If the current constructive narrative of good global growth remains intact, the US dollar should remain somewhat challenged.

Positive global conditions tend to favour the euro and emerging markets foreign exchange (including Asia).  And even as the Fed continues to raise rates, the US cycle is getting long in the tooth, whereas the monetary tightening cycles in other developed economies are in their respective infancies.

However, if US led protectionism broadens and deepens, threatening the positive global story, the prospects for the US dollar become more ambiguous. In this world, emerging markets foreign exchange (including emerging markets Asia) and other globally-oriented currencies would likely underperform the US dollar, while the safe havens of the yen and Swiss franc would probably do well. 

The euro could outperform the US dollar as well, given its current account surplus and the possibility that a eurozone in the sweet spot of its business expansion is seen as a more attractive place to invest than a US that is late in its cycle and becoming calcified behind trade protectionism.