The exchange rate index of the US dollar had started 2017 at 103,2, after months of strengthening linked to concerns about the consequences of the French presidential elections on the stability of the Eurozone, and the effects of the election of Donald Trump on the expectations of growth operators. Since then, however, the decline has been almost uninterrupted: the exchange rate dropped to 91,3 in September, then rose again until November, then fell again to lows of 88,6 at the beginning of February.
The first phase of decline, in the spring and summer, is linked to the marked improvement in confidence in the euro which resulted from Macron's sweeping victory in the French elections. The turning point was so clear that investors subsequently proved completely insensitive both to the entry into the Austrian government of the Eurosceptic right, and to the beginning of a difficult electoral campaign in Italy, a campaign which could lead to a further erosion of the consensus for moderate parties.
The weakening of the dollar is linked to a dramatic increase in speculative short positions on derivatives. The phenomenon involved exchange rates against the euro, yen and sterling. The levels reached are unusual, and at least suggest the possibility of a corrective phase. However, also the presence of some sporadic exceptions, where the rebalancing (at least initially) took place without a weakening of the euro.
Another element is the link between the value of the dollar and risk aversion. Higher levels of the VIX, for example, are associated with a stronger dollar. Therefore, the correction of world stock indices should also be accompanied by a correction of the dollar. But what about the fundamental factors that should affect the exchange rate?
THE PUZZLE OF INCONSISTENCY WITH THE MOVEMENT OF RATES
Beyond the very short term, the euro-dollar exchange rate tends to move in the same direction as the differential between the 2-year rates between the United States and the Eurozone. Since 2007 the relationship has been impressive, with few lasting episodes of uncoupling. The two most relevant occurred in 2009 and 2014. In 2009, the world economy was still in the midst of the chaos associated with the Great Recession and the gap was absorbed in 2010 with a correction of the exchange rate towards values more consistent with the rate trend.
Once again in 2014, the re-engagement occurred with a rapid appreciation of the dollar, while differentials continued their orderly movement linked to the dynamics of monetary policies. The hang-up was then followed by an overshooting, with a euro/dollar exchange rate that was temporarily too weak. Today we are experiencing the third decoupling episode of the decade. This framework of analysis would suggest that the euro/dollar exchange rate should fall. The fair value calculated on the basis of the relationship prevailing since 2008 would be around 1,10 dollars per euro.
However, there are three considerations which must lead us to take this conclusion with a little caution:
1) compared to 2014, the relative dynamics of monetary policies could be a little less favorable to a rebound of the dollar: at the time the ECB was preparing the launch of the App, while now the markets are starting to discount the closure of the program stimulus and the return of European interest rates to positive levels after mid-2019. Therefore, markets may have a more subdued perception of the monetary policy divergence than in 2014;
2) between 2000 and 2006 the relationship was decidedly weaker, with long periods of total decorrelation. Furthermore, between 2003 and 2005, the gap closed with a convergent movement of the exchange rate and the differential. Therefore, on that occasion the latter gave a wrong indication of the trends. Indeed, at that time the United States was in the midst of a credit bubble and the current account deficit exceeded 6% of GDP in some quarters. The estimated relationship also including the period 1999-2007 produces a fair value of 1,25, substantially in line with current valuations.
3) A third problem is the impact of the Fed and ECB purchase programmes. Both are significant as determinants of the exchange rate, reducing the significance of the rate differential. Considering the impact of the APP, the fair value is slightly lower (1,23), and still in line with current levels. However, it is expected to rise sharply first with the reduction, and then with the closure of the APP.
CURRENT ACCOUNTS, COMPETITIVENESS, TRADE POLICIES AND EXCHANGE
As mentioned, between 2003 and 2005 the explosion of the current account deficit in the United States had signaled that the expansion was assuming an unsustainable character, and had contributed to breaking the correlation with the interest rate differential. Today the current account balance of the United States shows a deficit of about 2,4% of GDP, rather stable. A closure of this deficit by the exchange rate would perhaps require a depreciation of about 10%. However, there is no reason to consider this deficit unsustainable, and therefore to think that it requires a depreciation of the exchange rate. The role of the current account balance in explaining the exchange rate seems to be of little significance at this stage, even if it may become so in the face of wider imbalances. The relative dynamics of prices, on the other hand, are correlated with the trend of the euro/dollar exchange rate: relatively stronger European inflation is associated with a stronger euro. However, this aspect is unlikely to account for recent moves.
However, there is another element that may have influenced the attitude of investors towards the dollar: the mercantilist turn in American economic policy that occurred with the inauguration of the Trump administration. Shortly before assuming the presidency, Trump had judged the dollar "too strong". US Treasury Secretary Mnuchin said recently that "obviously a weak dollar is good for us, as far as trade and opportunity impacts are concerned." Trump corrected his argument by arguing that he wants to see a stronger dollar, but the perception that the Trump administration likes a weak dollar to complement its mercantilist policies has become entrenched.
However, the situation is more complex than it appears. For example, tax reform could be seen as positive for the dollar, insofar as it helps profit repatriation of American multinationals, stimulates direct investment in the United States, and eases domestic over foreign production. However, even setting aside doubts about the effectiveness of the reform in generating a repatriation of profits, the opposite consequence could arise if the worsening federal deficit shifts the savings and investment balance towards a higher deficit. From this perspective, it may require a weaker dollar.
OFFICIAL RESERVES AND DOLLAR
Partially related to the US policy shift following Trump's election is another theory, which links dollar weakness to changes in the currency composition of official reserves. The recomposition could be motivated by the desire to protect the country's financial assets from the risk of sanctions, or more generally by distrust of US foreign and economic policy. However, it is very difficult for countries that have to manage large foreign exchange reserves to change their composition significantly. Basically, in a phase of accumulation of reserves they will also have to be buyers of USTs. This is especially true for China, which has over $3000 trillion in foreign exchange reserves to manage.
US government bonds held by official entities have returned to growth after the decline connected to the contraction of China's foreign exchange reserves that occurred between 2015 and 2016, but remain lower than the previous peak. The IMF data on reserves actually show a decline in the dollar's share between end-2016 and 2017Q3 by 2 percentage points, from 65,3 to 63,5%, while the euro's share rose from 19,1 to 20,0, 4,0% and that of the yen from 4,5 to 78,6%. However, over the last year the share of official reserves allocated from a currency point of view rose from 85,4% to XNUMX% and therefore the changes could reflect more the change in the sample than an actual change in the currency composition.
Furthermore, the decline may also reflect the mere depreciation of the dollar on the foreign exchange markets: in the same period, the dollar depreciated by 6% on effective exchange rates, so that the decline in the value of dollar reserves could be half explained by a enhancement effect. Thus, while it is not unreasonable to think that a gradual shift towards non-dollar reserve currencies is in the offing, it is difficult to ascertain how much the currency rebalancing may have affected the recent dollar weakness. Perhaps, given the trend of speculative positions against the dollar and the importance of quantitative stimuli in influencing exchange rates, it is not even necessary to mention it.
BUT IS THE MOVEMENT OF THE DOLLAR SO EXCEPTIONAL?
To conclude, it is worth taking a look at the long-term trend in trade-weighted average exchange rates. From this point of view, the 2017 movement loses much of its exceptionality. The dollar is returning to its historical average, correcting an overvaluation phase that characterized the 2015-16 period. Full normalization would require a further depreciation of about 5%. Perhaps Trump was not entirely wrong in judging the dollar "too strong".
The euro remains within the norm for now, but the deviation from the long-term average is starting to approach one standard deviation. This situation is not common: since 2000, only in two cases has the effective exchange rate of the euro deviated from the mean by more than one standard deviation. In 2014, the detour was short-lived. Ten years ago, however, the deviation lasted for over two years before being reabsorbed.
On the one hand, there are other elements which suggest that a correction is ripening to release excess speculative pressure, and which also lead us to believe that the euro is close to being overvalued.
However, other considerations suggest that the euro/dollar exchange rate could today be at more adequate levels than it was a year ago, considering the greater focus on trade balances that occurred after the Trump administration took office. There are reasons to expect further dollar weakness despite the contrary indication from rate differentials. The closure of the APP, in particular, represents a potential risk for the exchange rate trend, since its launch seems to explain a large part of the drop in the euro/dollar exchange rate at the beginning of 2015 and its gradual reduction partly explains the recovery of the same exchange ratio in 2017 and 2018.
°°° The author is the head of macroeconomic research and the bond market of Intesa Sanpaolo
