After a decade of weakness, the U.S. dollar has appreciated strongly over the past couple of years, with a particularly strong surge in the first three months of 2015. Some market observers have begun to wonder if the rally has run its course. PIMCO doesn’t think so. “Although the currency markets will likely experience bouts of volatility, we believe the dollar should remain strong over the next several years. Here are three reasons why”, point out Scott A. Mather, Chief Investment Officer U.S. Core Strategies at PIMCO.
1) Diverging global growth and monetary policy trends
Recent economic data has raised some concerns that the U.S. economy may be cooling a bit. Nevertheless, we continue to believe the pace of growth in the U.S. will lead the developed world, while the eurozone and Japan will fall well short of self-sustaining growth.
On the policy front, the U.S. Federal Reserve has clearly signaled its intent to embark on a monetary tightening cycle in 2015. The first rate increase could come as early as June, though a disappointing jobs report for March and other soft economic data may make a September move somewhat more likely.
Other central banks, however, are on a very different path. Since December, a parade of some 27 central banks from around the world – including most major central banks, save the Fed – have eased monetary conditions by slashing policy rates toward zero or even below zero.
But importantly, global central banks aren’t just cutting policy rates; they are printing money through enormous quantitative easing (QE) programs. The European Central Bank (ECB) announced in January a €1.1 trillion QE program – much larger and more open-ended than the markets had expected. In December, the Bank of Japan redoubled its QE efforts by increasing its monthly purchases to ¥80 trillion. At this pace, the balance sheet of the BOJ will reach 70% of GDP by the end of 2015. So not only policy rate divergence, but also QE divergence, will drive the dollar higher compared with the euro and the yen.
2) The experience of past strengthening cycles
Moreover, it’s important to put the recent strength of the dollar in context. First, as Figure 2 shows, the dollar started from a multi-decade low relative to other major trade-weighted currencies. So while the recent appreciation has been impressive, the dollar has a long way to go given how low it started. Second, when the dollar appreciates, it is typically part of a multi-year trend. Again referencing Figure 2, previous strengthening cycles have occurred over many years with ups and downs along the overall path to greater strength. From 1980 to 1985, the dollar appreciated by more than 60%, and by more than 40% from 1995 to 2002.
3) The dollar’s resilience as a reserve currency
Related to global monetary policy divergence, central bankers also recognize this imbalance and are choosing to hold more dollars than euros and yen. Remember, central banks rank among the biggest players in the foreign exchange markets and exert tremendous influence on perceptions in the currency market. To provide a frame of reference, central bank reserves totaled $12.6 trillion in 2013, according to the World Bank. Following the 2008 financial crisis, central banks made a concerted effort to diversify the foreign exchange reserves they hold away from the dollar. In 2009, the share of foreign exchange reserves held in euros had risen to 28%. However, with Europe’s debt crisis in 2010, the euro’s appeal as a reserve currency began to decline. Last summer, in an effort to fend off recessionary pressures, European monetary policymakers reduced the central bank’s deposit interest rate to less than zero for the first time in history. That, plus the ECB’s aggressive program of quantitative easing officially begun in March, has made the euro significantly less attractive as a reserve currency and heightened the dollar’s appeal.
Investment implications
So what does this mean for investors? “The dollar will likely continue to appreciate, though the extent and pace of further gains will depend in part on the timing of the Fed’s initial tightening move. Nevertheless, given current economic fundamentals, the divergence in global monetary policy, the length of prior dollar strengthening cycles and the dollar’s persistence and prominence in central bank reserves, we continue to favor the dollar relative to the euro and the yen in particular. For those investors who find global stocks and bonds attractive – and PIMCO does – then carefully consider the currency exposure, lest the rising dollar sink your global gains”, said Chief Investment Officer U.S. Core Strategies at PIMCO.
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