Two sides to the US dollar story


Key points

  1. We see room for ongoing US dollar strength versus most developed market peers and further depreciation against EM currencies.
  2. Global stocks rose on hopes of progress in US-China trade talks. Lower oil output in January pushed oil prices to a three-month high.
  3. The Federal Reserve’s latest policy meeting minutes due this week could offer insight on the Fed’s “patient” approach.

Two sides to the US dollar story

Where is the US dollar headed after its sizable appreciation in 2018? It depends on your vantage point. The dollar has gained against most developed market (DM) currencies, but depreciated against emerging market (EM) counterparts so far this year. We see this trend as likely to run on in the short term in the absence of policy surprises.

Chart of the week

Yield differentials and year-to-date currency performance vs. US dollar

Chart of the week

Sources: BlackRock Investment Institute, with data from Bloomberg and Thomson Reuters, as of February 2019. Notes: We use two-year government bond yields as a proxy for currency yields. Currency yield differentials are the differences between the government bond yields of the country that issues a certain currency and those in the US The currency yield of the euro is represented by the average two-year government bond yield of Germany, Italy and France. Performance shown is as of Feb. 13, 2019, and represented by the change in each currency’s exchange rate against the dollar.

The dollar’s resilience this year has come as a surprise to some. A combination of rising risk appetite, slowing US growth and a Fed taking a pause in its monetary tightening would typically weigh on the greenback. Yet the same factors keeping the Fed on hold – slowing global growth and tightening financial conditions – are pushing other central banks toward a more dovish stance. This has helped the dollar retain its status as the highest-yielding DM currency and supported its modest gains this year. Most high-yielding EM currencies have also outperformed, as the chart shows. Yet interest rate differentials are not the only driver of currencies. The British pound’s fate is linked more to Brexit developments. And rising oil prices and risk appetite have helped the Canadian dollar’s performance so far this year.

What does a stable dollar mean?

The dollar’s yield advantage – the highest since early 2018 against a trade-weighted basket of G10 currencies – has led to a revival of the “carry trade.” Investors are borrowing in lower-yielding currencies such as the euro or Japanese yen, investing in higher yielders like the dollar and EM currencies, and pocketing the difference in yield (some of that “carry” is lost for investors hedging their dollar exposure). We see this trend as a key driver of currency movements in the short run – as the Fed appears likely to hold off on rate increases at least through the first half of the year, and other DM central banks are also expected to stay dovish.

A more stable dollar, coupled with a slowing but still growing global economy, underpins our positive view on EM assets. For one, it removes a key risk for emerging market economies with large external debt burdens. As many EM debtors borrow in dollars, a stronger greenback raises their borrowing costs – and tightens EM financial conditions. A more stable dollar also reduces the danger of taking on EM currency exposure, historically a large source of volatility for investors in local-currency EM debt. This underlies our recent call for a balanced approach to EMD, taking risk in both local- and hard-currency debt. We see both as attractive sources of income and are overweight EM equities. EM assets in general tend to perform well when EM currencies are rising. Risks to our positive EM views: an earlier-than-expected resumption of Fed tightening and the renewed dollar strength that would follow suit. 

Bottom line: We see the dollar holding its gains against most DM peers and underperforming EM currencies in the short term. Uncertainties in global growth and geopolitics cloud the longer-term picture. The dollar’s perceived “safe haven” role is likely to boost the greenback in the event of any return of recession fears or a resurgence in geopolitical risk. The dollar’s relatively high valuation may limit its upside in the long term. The real effective exchange rate – a key trade-weighted gauge of the dollar’s value – is sitting roughly one standard deviation above the 20-year average.

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  • Global stocks gained on hopes on the ongoing US-China trade talks. The VIX index, a gauge of US stock market volatility, fell to a four-month low. A drop in January’s oil output as reported by the International Energy Agency helped send oil prices to three-month highs. US President Donald Trump signed a spending bill to avert a second partial government shutdown in two months.
  • Companies representing two-thirds of global stock market value have reported earnings, with single-digit annual growth in profits and sales. Over 70% of technology companies beat expectations, and energy sector earnings were surprisingly strong despite a sharp drop in oil prices in the last quarter of 2018. Japanese corporate earnings fell partly due to weakness in Chinese demand.
  • US economic data sent mixed messages. The December core consumer price index (CPI), which excludes volatile food and energy prices, beat expectations, coming in at 2.2%. But retail sales recorded their sharpest decline in more than nine years, suggesting a slowdown in economic activity that will likely be reflected in fourth-quarter gross domestic product (GDP).



  Date: Event
Feb. 19 Germany’s ZEW Indicator of Economic Sentiment
Feb. 20 Federal Open Market Committee (FOMC) Jan. 29-30 meeting minutes; eurozone business and consumer sentiment
Feb. 21 US durable goods; Germany, France, US, eurozone Purchasing Managers’ Indexes (PMI)
Feb. 22 German ifo Business Climate Index

The January FOMC minutes may shed more light on what the central bank’s recently adopted “patient” approach to its monetary policy means. Any hint that the Fed may still be looking to raise rates this year could spook the market. Fed funds futures currently indicate investors expect no rate changes for the whole of 2019. We expect the Fed to pause on any rate moves for at least the first half.

Richard Turnill
Global Chief Investment Strategist, BlackRock Investment Institute
Richard Turnill is Global Chief Investment Strategist for BlackRock. He was previously Chief Investment Strategist for BlackRock’s Fixed Income and active ...

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