The US dollar has risen sharply since the summer of 2014. In this article, we offer an analysis of the reasons behind this rise and the ways it differs from previous appreciation cycles. In particular, we will see how the emerging currencies have taken on a much greater role than before.
Why is the US dollar rising?
Apart from the Bank of England, the Fed is the only central bank in the developed world that could conceivably tighten monetary policy for the 2015-2016 period. Other major central banks have recently expanded monetary easing and could go even further in this regard (the ECB, BoJ, PBoC, BoC, RBA, RBNZ, Riksbank, Norges Bank ... the list is long). This divergence of monetary policy is the main cause behind the strong appreciation of the US dollar's real exchange rate since the summer of 2014.
The original catalyst for the US dollar's rise was the sharp rise in Fed funds projections (the "dots") in September 2014, when the members of the FOMC moved their Fed funds projections for the end of 2016 from 2.5% to 3%. The FOMC members have been lowering their "dots" at a steady pace since then. Nonetheless, the Fed seems likely to hike its key rates for the first time in nearly 10 years at its December FOMC meeting.
Many emerging currencies had already depreciated against the US dollar in the months following Ben Bernanke's announcement in May 2013 that the Fed may scale back its asset purchases (an event known as "QE tapering").
What is the US dollar rising against?
It would be a mistake to focus exclusively on the EUR/USD exchange rate to assess the latter's appreciation. Indeed, while the EUR/USD rate has been more or less stable at around 1.10 since early 2015, the US dollar has appreciated steadily in effective terms (with the exception of the second quarter, when the markets had to digest very poor Q1 data for the United States).
To properly measure a currency's performance, its evolution should be contrasted against a basket of other currencies. In the case of the US dollar, the basket of currencies used by the Fed is particularly relevant. This is because the Fed reviews the weightings of the various currencies each year based on the countries' shifting share of trade volumes with the United States. The Chinese yuan, which had a weight of less than 1% in the early 1970s, now represents 21%. The most important currencies in the Fed's current basket are, in descending order, the yuan (21%), the euro (16%), the Canadian dollar (13%), the Mexican peso (12%) and the yen (7%). All other currencies have a weight of less than 4%.
Between the summer of 2014 and the end of September 2015, the US dollar's nominal effective exchange rate rose by approximately 20%. But as can be seen in the graph opposite, which represents the contribution of the various currencies to the effective appreciation of the US dollar since 2014, the US dollar's rise against the euro contributed only about 12% to this movement. This differs from the US dollar's previous appreciation cycle (1996-2001), during which the euro's depreciation accounted for approximately one-third of the USD's rise in effective terms.
Currency trends in the neighbouring countries should not be overlooked, as the Mexican peso and Canadian dollar jointly account for about one-third of the US dollar's effective appreciation since mid-2014. The Canadian dollar has been under pressure from rate cuts by Canada's central bank coupled with the decline in oil prices. Meanwhile, lower oil prices and the prospects of policy tightening by the Fed have hurt the Mexican peso.
Nearly all of the depreciation of the euro, Canadian dollar and Mexican peso took place between the summer of 2014 and March 2015. While there may be room for these three currencies to decline further against the USD, much of their depreciation potential seems to have been exhausted.
Since May 2015, the US dollar's appreciation has been especially marked against the emerging currencies, particularly with the renewed fall in commodity prices. Thus, while the devaluation of the yuan had a very marginal impact on the rise in the US dollar's effective exchange rate, China's slowdown served to push up the USD as emerging currencies took a tumble.
Is the US dollar overvalued?
Despite its 14% rise since the summer of 2014, the United States' real effective exchange rate only recently exceeded its long-term average, whether judging by the numbers of the Fed or the BIS. According to estimates by the IMF, a 10% increase in the real effective exchange rate leads to an average reduction in net exports of 1.5% of GDP. At the conference held last August in Jackson Hole, Fed Vice-Chairman Stanley Fischer indicated that the real appreciation of the US dollar would have a negative impact on inflation as of the following quarter and throughout the following year while its impact on economic activity would essentially be felt in the second year after the increase occurred. Specifically, he indicated that the US dollar's rise would hamper growth in 2016 and likely also in 2017. It is evident that the appreciation of the US dollar does not help the US economy. However, being a relatively closed economy, the United States is likely to withstand the pressure. On the other hand, the downward pressure on inflation is likely to slow monetary tightening by the Fed, which could, by extension, constrain the rise of the US dollar. Indeed, the appreciation of the foreign exchange rate is effectively a form of monetary tightening. Several valuation approaches, namely those built on behavioural equilibrium exchange rate or purchasing power parity models, indicate that the US dollar is already overvalued, and this overvaluation, which is not yet extreme, could increase further in the coming months.
Since the end of the Bretton Woods system in the early 1970s, the US dollar has experienced two major episodes of real appreciation, both lasting approximately five years, between 1980 and 1985 and between 1996 and 2002. Both episodes saw periodic interruptions lasting several months. The current episode began only about 12 months ago and is unlikely to last as long as the previous cycles, as the US recovery in the current cycle is weak by historical standards and the Fed funds tightening cycle is likely to be even smaller in scale than currently envisaged by the Fed. Furthermore, several corporate indicators reveal that the credit cycle is already well underway.
If we observe the four major monetary regions—the United States, the eurozone, China and Japan—we can see that the only major currency with potential for appreciation is the US dollar. Since the Great Recession, exchange rate adjustments have favoured the real appreciation of the yuan. China has been the big loser in the post-2008 currency movements, as the US dollar has continued to appreciate in nominal terms against the yuan. In real terms, China's currency has risen 38% since August 2008, compared to only 13% for the US dollar, while the yen and euro have shed 16% and 18%, respectively. Such sustained real appreciation no longer looks realistic for China, which faces numerous internal imbalances. Meanwhile, deflationary pressure is preventing the eurozone and Japan from effectively absorbing an appreciation of their currencies. The ECB has already announced that it would beef up its monetary policy if this were to ever occur.
The appreciation of the US dollar can mainly be attributed to the divergence of monetary policy and to the deterioration of growth prospects in the emerging countries. The US dollar's current appreciation is unprecedented because the contribution of the emerging currencies is much stronger—and that of the developed currencies much weaker—than in previous cycles. Although it has already risen substantially, the USD retains some room for further appreciation in the coming months. However, any additional increase will not be very significant because it would risk excessive overvaluation.
The United States' real effective exchange rate only recently exceeded its long-term average