Robert Blews, 11 April 2018

One of the more puzzling developments in global markets is the persistent weakness of the US dollar against all major crosses. 

Going into 2017, just about everyone expected the US dollar to strengthen.

The US economy was performing well. Meanwhile, the US fed had commenced an interest rate tightening cycle, and was widely expected to begin shrinking its balance sheet by the end of the year. 

With the rest of the developed world’s economies still pursuing very accommodative monetary policies, it seemed there was only one way the US dollar could go – up. Of course, that did not happen. In fact, the US dollar index (which measures the US dollar against a basket of currencies) declined by 13 percent in 2017; one of the worst performances on record. 

What went wrong?

Was it concerns over twin deficits (trade and fiscal)? Has the market simply lost faith in the US due to Trump’s confrontational attitude and erratic behavior? 

Currencies are notoriously difficult to forecast. Most of the traditional academic relationships typically used, hold only over the longer-term. However, there is a relatively simple and compelling explanation for the US dollar’s recent underperformance: the US dollar is a safe haven currency.

Safe havens such as the US dollar tend to perform well in periods of disappointing growth, market volatility, or financial instability. The period from mid-2016 to the end of 2017 was only the second time in the last ten years where the global economy was in synchronized upturn. 

No wonder the US dollar performed poorly. As expectations for a manufacturing led global recovery took hold, investors rotated out of US equity and debt securities and allocated capital to more cyclical markets such as Europe, Japan, and emerging markets. As investors sold US dollars to purchase euro, yen, and emerging market currencies, the US dollar declined. 

The US dollar is a safe haven given its status as the world’s reserve currency.

It is also the case that the US economy is largely services based, with manufacturing representing only approximately 13 percent of US gross domestic product (GDP). Services are less volatile than manufacturing, and thus the US economy is less cyclical than Europe, Japan, or emerging markets. 

Of course, other factors influence currency movements and the US dollar’s performance in particular. However, in our view the safe haven status of the US dollar is responsible for the lion’s share of US dollar weakness last year. 

So what would need to transpire for the US dollar to strengthen anew?

A return of market volatility would certainly be a catalyst; and it is interesting that the US dollar appears to have bottomed in advance of the most recent period of volatility. 

A deceleration in global growth would be another reason for investors to rotate back into US securities and the US dollar. While global growth remains strong, there are some early signs that global growth is decelerating.

Stay tuned.