Is the dollar undervalued?
After the sharp decline since the beginning of the year, the dollar now has more balanced valuations but cannot yet be defined as undervalued. It's not the
US current account deficit to worry about. The deficit (the flow) is not particularly high and is highly financeable, while the net asset position (the stock) continues to be healthy, because America is long on foreign equity which rises in value and short on debt which costs almost nothing serve. In practice, America consumes more than it produces but finances the difference with the capital gains of its portfolio, made up of multinational companies on the assets and bonds to be repaid on the liabilities.
What weighs, then, on the dollar?
Own demerits and the merits of others. Among its demerits is the loss of the premium for possible structural reforms, primarily the fiscal one, in which the market has stopped believing until proven otherwise. Then there is modest economic growth in a mature cycle, which seems to prompt the Fed to soften its tone on future rate hikes. And we must not forget the political will of the Trump administration to obtain with a lower dollar the extra growth that it has failed to achieve with the reforms and with the reopening of negotiations on international trade treaties. Among the merits of others are the stabilization of Europe, the good growth of Asia and the improvement of the position of many emerging countries.
What could the dollar support?
The interest rate differential remains very favourable. Just think that a 2017-year Treasury yields more than an Italian BTP and almost five times that of a German Bund, while the XNUMX-year Japanese yields nothing. The possibility remains open that the US economy will accelerate again in the second half of XNUMX. If Congress were to succeed in enacting some reforms, the dollar would certainly recover ground. At the moment, however, buying dollars seems premature.
Where can the euro stop?
The euro is still undervalued, but from now on the approach to the long-term equilibrium level, between 1.20 and 1.30 against
dollar, it will be more challenging. So far we have seen a big rally in relief that the existential risks to monetary and political union have disappeared with the French elections. This relief then coincided with the arrival of the first results of the monetary and currency policy of recent years, which kept Europe in intensive and recovery therapy.
Today Europe is undoubtedly stronger, but it is understandable that policy makers want to keep it under observation for some time before declaring it completely healed. For now, intensive currency therapy has been suspended (the euro has revalued) but not monetary intensive care (rates remain below zero). If Macron pushes through his structural reforms, as currently seems likely, and if the German export industry has absorbed the loss of profits (but not market share) resulting from the revaluation without too much consequences, the euro will be ready for a further rise. For the time being, settling down for some time around 1.20 would be better. Going further immediately would lead to problems on the inflation front, which would undergo downward pressure, and on that of growth, which would slow down.
Is inflation definitely dead?
Markets think so, but central banks aren't so convinced. If the global economy truly accelerates again, they believe, demand will match potential supply. Unless there is an increase in productivity, which is only possible with a recovery in investment, supply will not grow enough to keep prices in check. Albeit with due caution, therefore, the central banks would like to raise rates, at least the nominal ones. However, the weakness of the dollar is intervening to curb them which, as usual, has a powerful reflationary effect because it forces the rest of the world to postpone any restrictive measures, on pain of excessive strengthening of the exchange rate.
The weak dollar has already led the Bank of Japan to step up QE, the ECB to be ostentatiously vague on tapering and the Bank of England to keep rates at 0.25 despite inflation close to 3 percent.
What does all this mean for bonds and stocks?
The weak dollar, forcing central banks to keep interest rates low and liquidity abundant, exerts a strong general support action on financial assets, but not in a homogeneous way. American exporters have an advantage, European exporters are harmed.
In practice, the bond portfolio will be kept in euros. The equity market will include US stocks (with at least partial currency hedging) and European companies oriented towards the domestic market.
