Is the US dollar too strong?

There are no indicators that can convey as much information about the state of the global macroeconomic situation as fluctuations in exchange rates (currencies). This is all the more certain when it comes to the deep and liquid foreign exchange markets of the major currencies of advanced economies such as the US Dollar (USD), the Euro (EUR), the Pound Sterling (GBP), the Swiss Franc (CHF) and the Japanese yen (JPY). The currency market is driven by capital flows, which are real-time responses to expectations about risk appetite, relative economic performance and interest rate differentials.

Over the past few months, the dollar has strengthened against major currencies to levels not seen in decades. In fact, the dollar index (DXY), a traditional benchmark that measures the value of the dollar against a weighted basket of six major currencies, is up more than 16% from pre-pandemic levels. , up more than 17% since the start of the year and up more than 27% compared to the post-pandemic low in early 2021.

US dollar index

(DXY index points)

Sources: Bloomberg, QNB analysis

The rise of the dollar did not occur in a straight line. At the beginning of the pandemic, the dollar was supported by significant “safe haven” demand from global investors. However, soon after, within a few weeks, the dollar fell against major currencies for about six months. This happened between May 2020 and January 2021, when the US rolled out faster and bigger stimulus measures than other economies. But the trend completely reversed thereafter, leading to a deeper appreciation of the dollar against all major currencies. This brings us to the next question: Is the dollar overvalued?

A common way of looking at currency “valuations” is to analyze trade-weighted, inflation-adjusted exchange rates, i.e. real effective exchange rates (REER), and compare them to their own long-term averages or historical norms. This measurement of REER is more reliable than traditional exchange rates because it takes into account changes in trade patterns between countries as well as economic imbalances in the form of inflation and inflation differentials.

Currency value deviation from the 20-year REER average

(in % in October 2022)

Sources: Haver, JP Morgan, QNB analysis

The October 2022 CPI REER situation seems to indicate that the dollar is actually overvalued by nearly 20% compared to its 20-year average. We believe that the conditions are not yet in place to reverse the upward trend in the dollar. Three factors support our analysis.

First, risk appetite is expected to remain subdued due to the prevalence of increasingly elevated political, geopolitical and other risks threatening the global economic outlook. These include the Russian-Ukrainian conflict, tensions in the Far East and financial stability issues. With investor and consumer sentiment vulnerable to negative developments, the US dollar is becoming a “safe haven” instrument against tensions in Europe and Asia.

Second, the outlook for US growth also looks stronger than in other major advanced economies. This is all the more remarkable as the current geopolitical and energy crisis has a disproportionate impact on Europe and other major energy importers. Faster relative growth in the US is likely to encourage investment in the US and thereby attract foreign capital. Which strengthens the dollar.

Third, expected real interest rates, which allow the medium-term interest rate to be adjusted using forward-looking inflation targets, should also move in a direction favorable to the dollar. This is not only due to the aggressive stance of the US central bank (Fed), but also the fact that US inflation has probably peaked. In contrast, inflation expectations have risen in the eurozone and Japan, where central banks are much more cautious about anti-inflation aggressiveness due to weaker economies and rising inflation levels, higher indebtedness. Real interest rate differentials are one of the most important catalysts for capital flows, as investors seek to invest their resources in assets that offer high real, risk-adjusted returns.

Overall, while the dollar may appear overvalued, the outlook remains solid with further growth potential due to geopolitical tensions, still sustained relative US economic performance and more attractive real interest rates. We believe the dollar should remain strong as other advanced economies are forced to remain in a more fragile position.

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