In 2007 the American rapper Jay-Z delivered a well-aimed slight against the dollar. In the music video for “Blue Magic” he cruised through night-time New York, leafing through a thick wedge of €500 notes rather than the usual wedge of Benjamin Franklins, or $100 bills.
His doubts over the US currency were well founded. Between 2001 and 2008 the dollar index – measured against a basket of major currencies – fell more than 40 per cent as the US government’s longstanding “strong dollar” policy degenerated into a hackneyed punchline.
As the Fed printed $2.5tn to prevent a deeper crisis it seemed only a matter of time before foreign central banks stopped laughing at a joke at their expense and dumped US assets – turning a long, slow decline into a full-blown crash. The deepening financial crisis actually provided some respite, as panicking investors dived into the safety of US Treasuries and lifted the currency. But the dollar index weakened again, nearly hitting a record low in 2011.
Now, though, investors, analysts and economists are predicting a resurgent run for the dollar.
After a torrid few years the US economy is showing signs of life again. The housing market – epicentre of the financial crisis – is recovering and unemployment is falling. As a result the budget deficit is being steadily trimmed and in December the Federal Reserve decided to start scaling back its $85bn-a-month emergency asset-buying programme.
Adding to the dollar’s tailwinds, the development of shale reserves is crimping energy imports and narrowing the current account deficit. Some analysts are contemplating the prospect of a surplus thanks to an industrial renaissance fuelled by shale gas.
Cumulatively these ingredients are enough to ensure a third great bull market for the US dollar, according to George Magnus of UBS.
“The US was the first into the crisis but the first one out. While I share all the reservations about how strong the recovery is, the fact is that the US dollar will reflect a competitive US economy, and is therefore in a very advantageous position relative to the other major currencies,” Mr Magnus says.
Since the collapse of the Bretton Woods system in 1971, when the dollar’s convertibility into gold was terminated, there have been three down cycles and two up cycles for the US currency, with an average duration of just over seven years, according to Mr Magnus. He expects the new dollar bull market to last into 2015.
He is not alone in predicting a renaissance. The dollar index has gained almost 11 per cent since its 2011 low, and – despite the euro’s recent resilience – is up 9 per cent at $1.36 against the single currency over the same period.
During the past year the greenback has gained chiefly against the yen and emerging market currencies, but now that the US budget imbroglio has been lifted and the Fed has moved to trim its quantitative easing programme, most analysts expect a broader rally against other major currencies.
The mean estimate of 84 economists surveyed by Bloomberg is for the US currency to strengthen by almost 8 per cent against the euro by 2015. The Japanese yen will fall by a similar amount against the dollar, according to analysts.
Luca Paolini, chief strategist at Pictet Asset Management, notes that the dollar strengthening against the Japanese yen is a “consensus trade”, but argues that many investors are still underestimating the dangers to the euro.
“The euro has been very strong, but that should change this year. The ECB is going to be much more dovish than most people expect, and we see a lot more risks in Europe than the US,” he argues. “Everything suggests that the US dollar will strengthen against the euro.”
While most expect the dollar to strengthen, not everyone is convinced that it will be a forceful recovery. Some analysts say it may be limited by the Fed’s insistent message that tapering does not represent monetary tightening – with the additional risk of tightening itself being deferred if low inflation in the US justifies an extension of the zero Fed funds rate beyond mid-2015. The dollar’s rise could also be stymied by another political logjam and budget fight in Washington.
Stephen Jen, head of the currency hedge fund SLJ Macro Partners, argues that “the trend for the dollar will be increasingly dictated by the economy, not what the Fed says or does”.
If those expectations are fulfilled, the implications could be profound. Japanese and European exporters will cheer, but dollar bull markets have historically caused turmoil in the developing world, most recently Mexico’s “Tequila Crisis” in 1994 and the Asian financial crisis in 1997-98.
The rising dollar increased the cost of dollar-denominated loans and caused currency pegs to snap, triggering corporate bankruptcies and government defaults.
Developing countries today overwhelmingly let their currencies float, and for the most part eschew borrowing in dollars. Many have healthy reserves to fall back on – unlike in the 1990s. But the vulnerabilities of the past have only been ameliorated, not eliminated, and many analysts expect a stronger dollar to prove challenging.