Since peaking in October, the dollar has declined against the currencies of every major trading partner except Japan, Mexico and Argentina. With US economic expansion forecast to fall short of the global average by a full percentage point or more in every quarter of 2018, the dollar’s downward trend is poised to continue. Central banks abroad are normalizing their monetary policies while the US yield curve is flattening, and few catalysts are left to reverse this downward trend.
Expectations for a dollar bounce in the first quarter have faded. Passage of tax reform modestly improved the growth outlook, but the trade-weighted dollar has since lost an additional 1.7 percent. While the new law incentivizes repatriation of overseas profits and may encourage a burst of foreign direct investment in US businesses, it may not be enough to overcome relatively slow US economic growth.
Political factors are also contributing to a dollar discount. The recent struggle surrounding the federal government shutdown raises concerns for the upcoming debt ceiling deadline, when legislative gridlock could risk a debt default. Trade protectionism is also back in the headlines. NAFTA renegotiations began in late January, and new tariffs on some Chinese goods have heightened tensions among the world’s largest economies.
Ultimately, the dollar’s fate will likely depend on developments abroad. For years, the dollar rose on widening rate spreads as the Fed hiked while Europe and Japan eased. Today, that dynamic appears to be reversing. The US is nearing the peak of its business cycle, while currencies abroad are enjoying the upside surprises that come from early to midcycle growth.
The Japanese economy has also lagged behind the pace of global growth and, like the dollar, the yen has underperformed as a result. In January, the currency’s nominal effective exchange rate dropped to its lowest point since February 2016.
The yen appreciated modestly following the Bank of Japan’s (BOJ) announcement that it would taper purchases of long-term bonds in January. However, the uptick appears to have been driven largely by the unwinding of short positions rather than a fundamental reevaluation of the currency. There’s little expectation that the BOJ can match the eurozone’s pace of monetary policy normalization in the foreseeable future.
The BOJ could see a leadership shakeup in the coming months. While Governor Haruhiko Kuroda is widely expected to be reappointed when his term expires in April, hawkish factions may support the candidacy of Takatoshi Ito or Hiroshi Watanabe. Both challengers have advocated for an exit policy clarifying when the BOJ will end quantitative easing.
The euro has rallied as Europe leads the global business cycle upswing. The economic boom pushed the euro up 13 percent against the US dollar in 2017, and eurozone growth in 2018 is expected to outpace expansion in the US and Japan for the third consecutive year.
An attractive investment environment is bringing strong capital inflows to the EU, and bond yields are expected to rise as the European Central Bank (ECB) tapers its quantitative easing program as a prelude to tightening in 2019. In December, the ECB hinted that it was considering an accelerated timeline for normalizing interest rates, but any potential revision to the bank’s forward guidance won’t be announced until later in the first quarter.
The eurozone boom should continue to support a strong euro this year, but the currency’s potential for dramatic gains may be limited. The widespread repudiation of euroskeptic parties in elections across the continent last year has nearly eliminated the currency’s political risk premium, leaving the euro slightly overvalued. As a result, the currency’s near-term appreciation may be modest, even as the continent’s business environment continues to improve.
Fears of a hard Brexit seem to be subsiding. Negotiators have agreed to maintain the UK’s economic access to the common market for two years following the nation’s official EU exit in March. Prime Minister Theresa May also appears to have headed off opposition from the hard-line euroskeptics in her party, which should support more conciliatory negotiations.
Although immediate risks to the British economy are fading, the ultimate fate of Brexit negotiations remains unclear. The two sides have yet to reach an agreement that will preserve the UK’s ability to trade freely across the continent—an important consideration for its large financial sector. This uncertainty has led investors to retain a sizable risk premium when valuing the pound.
As negotiations drag on, the underperformance of the British economy is likely to constrain the pound. The Bank of England is set to hike interest rates later in the year, but the decision to tighten policy appears to be driven by inflation, not expansion. If the eurozone continues to outpace British growth, the pound could soften further in 2018.
Source: J.P. Morgan Global FX Strategy & Global EM Research, Key Currency Views; published January 12, 2018.
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