You may have noticed that a US dollar goes a lot further in much of Europe than it used to. In fact, it goes about 25 per cent further. From our colleagues at FastFT:

Put another way, the euro fell by 20 per cent against the dollar in less than a year. One popular explanation is that weakening economic conditions increased anticipation that the European Central Bank would buy a lot of bonds, which would somehow cause the euro to depreciate against its trading partners. (Cue “currency wars” rhetoric.)

This story isn’t completely wrong, but it’s worth comparing the euro to other currencies to get a sense of what has really been driving the move in EURUSD. The chart below compares the performance of the euro against the other major (floating) currencies over the same period, indexed to start at 100 so that it’s easier to make comparisons:

The euro actually appreciated against the Swedish krona and Norwegian krone since the start of 2014. If we start on July 1 — when the euro began its precipitous drop against the US dollar — the single currency fell by less than 6 per cent against the pound and held its value even better against the rest of the floating currencies in the G10. (We exclude the Swiss franc because it had been held below its fair value by the Swiss National Bank for several years, only to spike upwards once the intervention ended.)

For comparison, here is the dollar against those same currencies. Notice anything different?

For one thing, there’s the scale. The euro just hasn’t moved that much against the other G10 currencies when compared to the big swings in the US dollar. The other difference is that while the euro moved up against some currencies and down against others, the dollar has soared against practically everyone else. Since July 1, the greenback appreciated by more than 14 per cent against sterling and significantly more against the other currencies in our sample. Even the Swiss franc’s recent spike only brought it back to where it was at the beginning of May, relative to the dollar.

This reinforces our view that any weakness in euroland is insignificant compared to the forces powering the rise of the dollar. So what could be going on?

In general, currency movements are driven by changes in relative rates of return that cause investors to buy and sell assets across borders. Trade in goods and services is quite small relative to gross flows of capital in and out of most countries. Besides, it takes so long for businesses and households to adjust their supply chains and consumption habits to keep exchange rates in line with “purchasing power parity” that the concept only has theoretical value. Investments in securities move much faster, which is one reason why imbalances in trade and savings behaviour can persist for such a long time.

(We dare you to trade currencies using PPP or The Economist’s Big Mac Index, which indicates you should load up on rubles.)

It’s no secret that the US has been the world’s cleanest dirty shirt when it comes to economic performance over the past few years, although the slowdown in China and the associated impact on commodity producers has made the contrast starker. Within the rich world, the Federal Reserve is poised to “normalise” interest rates as the economy accelerates while the Europeans, Canadians, Japanese (and Australians?) struggle to ease monetary policy even further in response to slowing growth and inflation. Meanwhile, the growth in dollar-denominated debt owed by borrowers in emerging markets since 2008 presents the possibility of a short squeeze.

The logical outcome would be for foreigners to send more money to America and for Americans to start bringing capital home from abroad. In both cases, the goal is to earn a higher return, and many investors don’t fully hedge their currency exposure when investing across borders. As it happens, we have some evidence that Americans have begun selling foreign assets to bring capital back home, which, all else equal, ought to put significant upward pressure on the value of the dollar.

Via Citi:

Inflows associated with selling of foreign stocks and bonds by US investors hit its second highest level ever in the four-months through October, with more than $90bn in inflow into the US. This pace of repatriation sits somewhat below the record four-month inflow of $111bn seen in November 2008, while it outstrips the next closest bouts of repatriation of just under $50bn in early 2012 and $40bn in 1998.

There has been more back and forth in US buying and selling in foreign securities since the onset of the global financial crisis, so it is possible that the recent trend is simply symptomatic of higher volatility. However, the present bout of repatriation looks markedly different from that seen in the past. This is because it comes in a (largely) risk-positive environment as opposed to in an environment of widespread risk aversion as was the case with nearly every other episode of US repatriation save for that seen over the course of the tech boom in the early 2000s.

It is far more typical for US investors to cut foreign holdings (and buy USD) as a function of flight-to-safety, so the recent pattern suggests a break in trend. It is likewise possible that the end of US quantitative easing contributed to this trend. This has important implications for trade moving forward, since economic and policy divergence between the US and other economies does not appear to be narrowing. Insomuch as this supports expectations for outperformance from US assets, this could see continued repatriation moving forward as investors up allocations to US securities.

There is scope for this trend to run. The roughly $80bn in repatriation since the beginning of August reverses less than half of the $210bn in outflow seen since summer 2013 and less than one-third of the more than $370bn since September 2012. Indeed the trend has most often favoured outflow from US investors since the Treasury began tracking capital flows in the late 70s, so if anything the above understates the degree to which US investors could cut foreign holdings. It is farfetched to believe that US investors would cut foreign holdings entirely, but the potential overhang of USD buying is nevertheless large.

The key thing here is that this doesn’t have that much to do with the actions of the ECB. Dollar strength due to improving growth prospects — not euro weakness due to monetary stimulus — is the real story.

(These movements also have little do with what’s “best” for the US or any other country. While Americans have done an impressive job reducing their domestic and international imbalances since the current account deficit peaked in the mid-2000s, global demand is still unevenly distributed, making the world economy more fragile than it needs to be. Switzerland’s recent move to let its currency float is a positive development, but the soaring dollar won’t do anything to encourage Germany or the Netherlands to rebalance their economies away from excessive savings and over-reliance on exports towards more balanced growth.)

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