A Bull or Bear Outlook for the Dollar?

The current dollar bull market started in 2011, and it has been advancing as all dollar bull markets do, based on growth outperformance. Private sector growth outperformance typically drives the U.S. dollar since it also is what drives capital flows. Additionally, dollar bull markets tend to parallel higher U.S. interest rates. Technology leadership and energy, including the rise of shale gas and oil and the resulting U.S. energy independence, have played important roles in support of current dollar strength as well.

Meanwhile, the rest of the world generally experienced a weaker growth profile over this time period. For much of the 2010s, the European economy was languishing. China also has seen its growth trajectory turn lower, which has had consequences for commodity prices and other emerging markets. This contrast relative to the U.S. has been quite strong. However, unlike the 1990s when U.S. growth was exceptional for a fairly long period, both on a relative basis and outright, growth during the current dollar bull market has been more muted. Instead, it has been this contrast with the rest of the world that has propelled the dollar higher.

Furthermore, there is a distinction to be made over the course of the current dollar bull market. The dollar advance in 2011 and 2019, in particular, was driven by true private sector dynamism in the U.S. This trend was paralleled by tremendous U.S. equity performance and expansion of household net worth. However, there is a different quality to the dollar's advance post-COVID than what we saw previously. This time, the U.S. economy outperformed largely because of tremendous fiscal policy support. There are elements reminiscent of the dollar in the early 1980s, when there was an easy fiscal/tight money dynamic. The Reagan tax cuts set the stage for Federal Reserve (Fed) Chair Paul Volcker to tighten monetary policy further, and that dual combination propelled the dollar higher.

The U.S. fiscal policy response to COVID was remarkable and certainly bigger than most other parts of the world. And because it was so much bigger, the Fed had to respond more aggressively. When looking at the dollar’s advance, one striking data point is household net worth. From around 2013 to 2019, household net worth expanded sizably. At the same time, government debt levels drifted higher, but only minimally, suggesting a lot of pure private sector wealth creation. Over the last three years, net worth as a share of U.S. GDP has expanded modestly, but the fiscal balance sheet expansion has been comparable. In other words, the net worth expansion has roughly equaled the expansion of government debt. There has been a large transfer of wealth from the government to the private sector, which is not true growth, or at least not sustainable growth. This recent shift represents a very different aspect of the prolonged dollar advance.

Could technological advances, like AI, continue to increase productivity and investment, extending U.S. growth exceptionalism?

We attribute the dollar’s additional recent advance to this fiscal story than to true private sector or tech-led stories. However, this view of the dollar does not mean the U.S. is somehow significantly less exceptional than it has been. It is simply to argue that the dollar has scope to return to levels seen back in 2019, which is still consistent with a strong U.S. economy and growth outperformance.

Would a fiscal cliff or real reduction in fiscal spending reverse some of the dollar's advance?

Most of the significant fiscal policies the U.S. has employed over the last several decades were countercyclical. For example, the government increases spending or cuts taxes when the economy is weak, which is appropriate. Since the 2018 tax cuts, there has been a shift to using fiscal policy even when the economy is strong, which potentially makes the Fed's job harder. Almost every part of the world slowed below trend in 2023, with the exception of the U.S. The main difference, however, was the U.S. government deficit got a lot worse.

Going forward, a fiscal cliff may not be necessary, but that rate of change of fiscal policy expansion should slow. It seems fiscal policy has reached an inflection point and likely will not offer the same support this year. Additionally, the Fed has not cut interest rates yet. So, there are reasons to think the U.S. economy will slow relative to last year as fiscal support wanes.

How might Fed policy changes and rate divergences influence the dollar?

Ultimately, monetary policy and currency cycles track the relative outperformance of labor markets. When labor markets are strong, central banks become more worried about wage growth and therefore inflation. What is distinctive about the last three years, unlike the prior seven years when the dollar was going up, is that the U.S. labor market was clearly outperforming. Meanwhile, unemployment was rising in Europe. That is not true anymore. Europe's unemployment rate is now at record lows. The labor market differential between the U.S. and other countries is not nearly as extreme as it used to be, and this environment is consistent with a narrower interest rate gap between the U.S. and the rest of the world. How much the Fed will cut depends on a lot of factors. However, we believe the yield spread—the excess yield one gets in U.S. short-term interest rates—will narrow versus the rest of the world over the coming year, creating a headwind for the dollar.

Are there other U.S. election dynamics that may impact the dollar trend?

One risk is a Donald Trump presidency potentially would bring further protectionism. All things being equal, higher U.S. tariffs would tend to depress other currencies as they adjust to the relative expensiveness of their exports to the U.S. However, Trump also has complained about the strength of the dollar—he wants a policy that is supportive of U.S. competitiveness. To simply raise tariffs along with a strong dollar does not achieve that objective. How he gets a weaker dollar is a different question. One possibility is through the Federal Reserve and his replacement for Jay Powell in 2026. Other risks revolve around whether the authorities find yet more money to spend, prolonging this easy fiscal/tight money dynamic that has been supportive of the dollar. Unfortunately, a significant call from either side of the aisle has been lacking to really take the federal debt issue more seriously on a structural basis. While it is a concern, significant incremental fiscal support is unlikely. However, bringing U.S. debt levels down would require cutting fiscal expenditures or raising taxes. These moves would be dollar negative, but a significant amount of change also seems unlikely on that front.

How might geopolitical and other risks impact the “dollar smile” concept?

The dollar smile refers to the idea that at the extremes, the dollar does well. If the economy is too hot, the Fed has to be more heavy-handed on monetary policy, and typically that more risk-off environment tends to be dollar bullish. On the other hand, a hard landing that causes risk assets to struggle also tends to lead to safe-haven flows into the dollar. Where the dollar usually struggles is in the middle, which is the period in which global growth is benign, resulting in less of a reason to hold dollars from a safe-haven perspective. One could argue this has been the environment over the last 18 months. The dollar is down over that period, despite the fact that U.S. growth has outperformed, particularly last year. Why? Other places now also have decent growth or interest rates, pushing the greenback to the middle of that dollar smile and resulting in more mixed relative performance among currencies.

Which developed market currencies may fare well or poorly against the dollar in the near term?

Over the last year in particular, the U.S. outperformed much of the developed world. But currencies have not responded as one might expect in that context. The most notable example is the euro. The euro has rallied over the last 18 months, even as U.S. growth has outperformed European growth. That might speak to valuations as the dollar is more expensive at this stage. However, the structural overhang with which Europe struggled for a long time is over. The banking crisis is over. The sovereign crisis is over, and some of the best-performing countries now are the southern European economies that struggled for so long, Spain and Italy in particular. The Italian equity market has been one of the strongest performers this year. So, investors may be acknowledging that there is a better structural underpinning in Europe.

The currencies that have struggled most in the developed world, and even to some extent among emerging markets, are currencies closer to China. It is there we have had the biggest growth disappointment. Improvement in the commodity cycle or simply better growth prospects out of the region would help those currencies. The yen in particular has been one of the worst-performing currencies over the last several years. As the world raised interest rates, the Bank of Japan, of course, did not. This stark contrast in monetary policy has weighed heavily on that currency. What is important to consider is that Japan is in a different stage of its cycle. While inflation and wage growth are slowing in most parts of the world, including the U.S., the opposite is true in Japan, and policy may need to change quite significantly on a relative basis. The yen, which is a very cheap currency, has the most potential to appreciate, but the timing of a policy shift from the Bank of Japan has been difficult to pinpoint. But these expectations can be seen most visibly in the performance of the equity market. In this year alone, despite the yen’s weakness, Japanese stocks have been a better place to invest, outperforming in dollar terms despite all the AI-led excitement in the U.S. equity market.

What is the landscape for emerging market currencies, which generally have not fared well lately?

There are some encouraging trends in emerging markets. The resilience of some of these currencies in 2022, like the Mexican peso and Brazilian real, in the face of a tremendous Fed tightening cycle was remarkable. That likely had a lot to do with the fact that many of these countries pursued more orthodox policies than the Fed. Of course, performance has not been uniform for all emerging markets. Several, including South Africa and Asian countries, have struggled. But the dollar rally is starting to narrow, which may be partly indicative of a dollar top. Some currencies begin to outperform at a certain stage, and we have started to see that sequencing unfold with the higher-yielding emerging market currencies.

What are the expectations for the U.S. dollar near term and over the next few years?

We expect the dollar to return to levels seen in 2019, which is about 10% weaker from where we are today. That depreciation is in the context of a U.S. economy that begins to run low on fiscal juice. Additionally, as the Fed starts to have reason to pare back some of its hikes, more dollar normalization is likely. We do not expect some major dollar bear market as seen in previous eras. But as this government fiscal piece comes out, we expect the dollar will be somewhat weaker. A risk that could delay this outlook is that there is more resilience and inflation persistence in the economy. The growth numbers in the first half of this year, particularly in the U.S. labor market, will be important to watch.