But while the currency has been range bound for the past two years, there are three reasons why I would expect a stronger dollar over the next year:
1. The US economy is improving. As I discussed in a recent post, the economy is firming, and it’s improving at a pace faster than most other developed countries. For 2014 I would expect U.S. growth of 2.5% to 2.75% versus less than 2% for Japan (EWJ) and as little as 1% for Europe.
But the U.S. recorded a small aberration in Q1 this year. As this series mentioned earlier, the U.S. has been leading the pack of developed countries (VEA) as far as economic data is concerned. While the Fed will increase interest rates soon, other economies need to keep lower interest rates in order to support growth in their respective economies, leading to an inflow of funds to the U.S. This will cause the U.S. dollar to appreciate in the short term.
2. The Fed will be pulling back at a time when many other central banks will need to maintain an ultra-loose monetary policy. By the end of the year, the Fed is likely to have exited its quantitative easing program. In contrast, most other developed market central banks – with the possible exception of the Bank of England – are likely to remain in an easing mode. In particular, the Bank of Japan will continue with its very aggressive asset purchase program for another couple of years. This should lead to a weaker yen.
3. Valuation. Today, based on purchasing power parity, many of the key developed market currencies look expensive relative to the dollar. Based on the Purchasing Power Parity Index compiled by the OECD, the Swiss Franc and the Australian dollar look to be 25% or more overvalued against the dollar, while the Canadian Dollar and British Pound look 10% to 15% overvalued, and the Euro appears roughly 5% above where fair value would suggest it should be. Of the major currencies, the yen looks the cheapest relative to the dollar, but as stated above, it’s still likely to weaken on the back of aggressive easing by the Bank of Japan. So how is a stronger dollar likely to impact the major asset classes? Historically, a stronger dollar has helped corporations in Europe and Japan, as a weaker domestic currency translates into stronger earnings. This is likely to be particularly true for Japanese companies, which are levered to global trade. On the flip side, a stronger dollar represents a modest headwind for U.S. profitability and by extension, U.S. earnings growth. Emerging markets, meanwhile, are even more vulnerable. A strong U.S. dollar hurts countries dependent on foreign funding, and as those countries prop up local currencies by selling dollars, this effectively tightens local monetary policy. In particular, I would watch out for countries in Eastern Europe. Finally, a strong dollar is deflationary and therefore negative for inflation hedges, most notably gold.
Market Realist – To read more about the dollar, please read 3 things to know about currency hedging.