Could the US dollar have reached a peak?

The currency markets have changed along with the global economy over the years; emerging-markets that were previously deemed as a minority are now representing a far larger share of the global economy and world trade. In turn, this has made their currencies more significant when measuring the US dollar’s movements.

US$ Bull Market

The US dollar has seen a long rally but has now backtracked a bit and not made much progression against other major currencies. However, it has appreciated against emerging-market currencies, which suggests there still may be room for the bull market to run.

Between 2011 and 2017, the dollar advanced by about 37% against a number of currencies, marking the third long-term bull market for the dollar in modern history. Unlike the previous two bull markets, the current one has been slower and more prolonged.

The major drivers behind the dollar’s bull market have been the strong performing US economy and higher US interest rates.

Typically, countries with higher interest rates and stronger growth tend to have stronger currencies because they attract foreign capital since they provide higher expected rates of return; this is exactly what happened in the US with the US dollar.

After the financial crisis, economies outside the US have been slower to recover, and central banks in Europe and Japan have kept interest rates low, or even negative in efforts to boost economic growth.

Consequently, holding other major currencies like the euro or yen is unattractive to most investors in comparison to holding the dollar. Interest rate differences can be a major driver of relative currency valuations.

Bond investors and currency values

The movements of currencies can have significant effects on the rate of return of a portfolio of investments – a factor of utmost importance to bond holders. Foreign bonds can provide important diversification benefits and at times attractive returns to investors.

However, even when investing in bonds with higher yields than provided in the US, such as emerging-market bonds, the currency return can reduce or even completely offset the return from interest payments and price change. This is the case whether an investor is exposed to hard currency bonds or not.

Possibility of lower ahead but neutral for now

The Federal Reserve has signalled a pause in its rate hikes amid signs of slower growth, and geopolitical concerns regarding trade tensions with China and uncertainty surrounding Brexit, among others, appear to be easing, reducing safe-haven flows into the dollar.

A turnaround in the dollar's trajectory will likely require stronger growth outside of the US and signals of tighter monetary policy abroad. That doesn't appear likely until later this year or beyond. While the Fed has signalled a pause in its rate hikes, it hasn't ruled out more rate hikes down the road.

Emerging-market currencies tend to be particularly sensitive to changes in monetary policy by the Fed, benefiting from Fed easing and being adversely affected by Fed tightening.

Currently, there is a neutral view of international developed country bonds and emerging market bonds. For the dollar to weaken significantly from current levels, it will likely require a combination of signs that the Fed is poised to ease policy while growth is picking up abroad. However, for now, the dollar is likely to remain firm.