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One of the many surprising aspects of financial market performance over the past year has been the weak performance of the US dollar, which has fallen by close to 10 per cent on a trade weighted basis and by more than 10 per cent against the euro.
This has occurred despite a variety of factors that might have been expected to push the dollar up. They include upwards revisions in economic forecasts, expectation of monetary tightening, rising real and nominal long-term interest rates, fiscal stimulus on a huge scale in a full employment economy, rising protectionism that should choke off import flows, and tax reform directed at reducing capital outflows and increasing capital inflows.
It is instructive to consider what the combination of interest rates and current exchange rates says about market expectations of future currency values. US 10-year interest rates are about 230 basis points above German rates and about 280bp above Japanese rates. This implies that markets expect depreciation of the dollar by more than 25 per cent against its major competitors over the next decade. If dollar depreciation of this magnitude was not expected, investors would prefer dollar assets to foreign assets, given the interest rate differentials. Some but probably less than half of the dollar’s weakness can be explained by higher than expected inflation in the US. Real interest rates imply an expectation of continuing real depreciation.
Given the movements in interest rates in the past year along with the dollar’s fall it is reasonable to estimate that expectations of exchange rates of the dollar against the euro 10 years from now have fallen by perhaps 15 per cent. Information on real yields suggests that much of this move reflects expected declines in real exchange rates.
Exchange rates are relative prices and to understand dollar fluctuations one has to look at what has happened in the US as well as other countries. It is true that the improvements in the US economic outlook are smaller than those in Europe and in a number of other countries. To the extent that dollar weakness reflects disproportionate improvement abroad, it undercuts claims that US policy is the reason for recent strong performance since Donald Trump is not president of the whole world.
But this is only a partial explanation. If it were the dominant story one would expect to see rates in other countries rise more than in the US as they experienced larger increases in demand for investment funds. This has not for the most part happened. For example, both US real and nominal rates have risen relative to European rates. Put differently, expected forward exchange rates have declined more than current rates. The dollar’s weakness has also been pervasive against Canada and Mexico, which have not had growth surprises.
The pattern of higher interest rates and a weakening currency suggests that on multiple dimensions US assets now have to be put on sale to convince foreigners to hold them or induce Americans not to diversify into overseas assets. This pattern is relatively uncommon in the US though it happened in the Carter administration before Paul Volcker’s appointment as chair of the Federal Reserve and in the Clinton administration before Treasury secretary Robert Rubin’s invocation of the “strong dollar” policy. It is fairly ubiquitous in emerging markets where it reflects anxiety over a country’s policy framework.
I fear such anxiety may be emerging in the US. Mr Trump and Treasury secretary Steven Mnuchin show their ambivalence about a strong currency. Washington consciously takes budget deficits way up in a full-employment economy. Questions arise with respect to the Fed’s independence, America’s traditional receptivity to foreign investment and its willingness to lash out at holders of dollar assets.
These concerns are greatly magnified by the decision last week to impose across the board tariffs on steel and aluminium. The decision to invoke national security trade protections over the objection of the defence secretary raises questions about the coherence of policy processes. The fact that declines in the aggregate US stock markets were about 100 times as much as the gains for steel and aluminium companies illustrates that because the steel using sector dwarfs the steel producing sector, the net effect of the tariff policy is to reduce US competitiveness even before considering foreign retaliation. And then there is the risk that a president who likes trade wars will have more of them.
The confidence of global markets is much easier to maintain than to regain. Currency markets are sending a signal that the US is not on a healthy path. Its time for the US to strengthen the strong fundamentals on which a strong dollar and healthy economy depends.
The writer is Charles W Eliot university professor at Harvard and a former US Treasury Secretary