Last year, the U.S. Dollar Index, a measure of the U.S. currency’s strength against a basket of foreign currencies, weakened almost 10%. This was the index’s worst performance in more than a decade. Meanwhile, the U.S. dollar depreciated against 85% of all major currencies. After such a dismal performance, the dollar may have been expected to correct that weakness coming into 2018 – particularly considering the early passage of U.S. tax cuts and outlook for Federal Reserve (Fed) monetary tightening. The tide, however, may be moving in the opposite direction.
The U.S. tax-reform bill has, as one would expect, boosted U.S. economic confidence. But it is not likely to have a meaningful impact on U.S. growth – in fact, market forecasts of U.S. growth have barely moved. So, the bill puts little upward pressure on the U.S. dollar.
The change in how foreign earnings are taxed is one specific factor within the tax reform bill that perhaps could be expected to give the dollar some respite. That change should encourage the repatriation of corporate profits and an inflow of U.S. dollars. But analysis suggests that most of the foreign retained earnings are already denominated in dollars, so any flows would have little impact on the currency.
Fed tightening would usually push the greenback higher. But disappointingly low inflation numbers have meant that the market is expecting fewer interest rate hikes than the Fed’s own projections. This dovish rate outlook, coupled with the fact that many central banks around the world are set to tighten policy this year – making it harder for the United States to attract broad-based international capital flows – is weighing on the dollar.
Actually, it isn’t that unusual for the U.S. dollar to weaken while the Fed is tightening. In the 2004 to 2007 hiking cycle, the Fed raised rates 17 times to a peak of 5.25%. Yet over that same period, the U.S. Dollar Index weakened by over 10%.
The U.S. dollar’s weakness has, in fact, coincided with an acceleration in global growth momentum. While U.S. growth forecasts have been upgraded only slightly in response to the tax reform bill, they have been overshadowed by upward revisions to GDP forecasts around the world, including Japan and China. In addition, the euro area is set to outpace the United States once again and, in fact, I expect the euro to be one of the star performers of 2018. In other words, the concern for the U.S. dollar isn’t that U.S. economic performance is disappointing, it’s that the global economy is simply doing better.
Overall, I see the U.S. dollar moving sideways or lower against most major currencies this year. There is one clear winner from this: emerging markets (EM). Since the late 1990s, EM equities have tended to outperform when the U.S. dollar weakens, and have struggled when it strengthens. This is because many companies in EM borrow in dollars, and dollar-denominated debts become cheaper to service when the greenback depreciates, loosening financial conditions and improving growth prospects for EM. The future may be dull for the U.S. dollar, but it is bright for emerging markets.
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