The Value of the Dollar

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One reason that currency forecasts are a formidable challenge is that they don’t exhibit any form of cash flow to anchor their value. Bonds have coupon payments while equities have earnings or dividends as cash flows that can be discounted back to arrive at some present value for the asset. So what factors can we rely on to forecast the direction of currencies?

In the short term, we believe in a regime-dependent approach that incorporates momentum, sentiment, and other macro based factors to forecast near term currency direction. Over the intermediate term, we look at relative interest rates and growth rates which can make domestic assets attractive or unattractive versus foreign assets. Using a two factor model based on interest rate and growth rate differentials, we estimate that a 100-point shock in the relative Citi Economic Data Change Index for the U.S. versus a basket of its majors would push the dollar roughly 10% higher in a years’ time, while a 1% shock in 2-year rate differentials would also push the dollar higher by roughly 10% over a years’ time. We also rely on other longer term signals to help form our secular view. Looking at the long-term view for the dollar, we start with purchasing power parity (PPP), which compares relative prices for goods and services, as our valuation anchor. Knowing this can deviate from fair value for periods of time, we view this as useful once it reaches stretched levels while also looking at this in conjunction with metrics such as relative current account balances and productivity which can justify periods of sustained over/undervaluation.

Putting all this together, we believe that in the near term we could continue to see some modest dollar strength as relative economic momentum and interest rate differentials are supportive along with market positioning that is fairly dollar negative. Any positive announcement on the tax reform front will also support a higher dollar in the near term as well. However, looking at the longer term view, with the flat trend of relative productivity and expectations for an increasing deficit, the dollar has room to move lower as PPP vs. a basket of its majors is currently neutral and has room to move to the downside.

Please look at page 54 of the Global Perspectives Book to see how the dollar has fared against emerging markets.

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