Why is Dollar Not Gaining Despite U.S. Rate Increases?

  • The Federal Reserve may be well set on its interest-rate raising course this year, but gains in the dollar could prove harder to come by.
  • The key reason why the dollar’s gains are slowing: The U.S. is no longer the sole bright spot in the global economy.
  • Sure, the world’s largest economy has recovered enough for the Fed to start normalizing interest rates after years of near-zero levels.
  • But the eurozone is now growing faster than the U.S.
  • In Japan, where officials have resorted to unorthodox measures in the past five years to stoke inflation, prices are finally rising slightly.
  • Both the Bank of Japan and the European Central Bank left monetary policy unchanged at their latest meetings.
  • In China, economic data has been solid so far this year.
  • Dollar’s losses after the Fed raised overnight rates seems to contradict common economic wisdom, which dictates that as the U.S. raises rates before other major global central banks, the divergence should boost the dollar. Higher interest rates tend to boost the allure of a country’s assets, which in turn tends to attract capital.
  • While that may yet prove true, the U.S. currency’s already sizable advance since 2012 may lead to diminishing future returns, some investors say.
  • The ICE U.S. Dollar Index has risen each year since 2012. The bulk of the rally happened in 2014 and 2015, when the index advanced by 12.8% and 9.3%, respectively; in 2016, it gained 3.6%. More than half the index’s weight comes from the euro, followed by the Japanese yen, British pound, Canadian dollar, Swedish krona and Swiss franc.
  • The scene was different during the great dollar surge of 2014-2015. While the Fed had just started winding down its post-financial crisis bond-buying program, central banks in Japan and Europe were busy buying up government bonds to stimulate their persistently sluggish economies, keeping bond yields low globally.
  • The yearslong move higher in the U.S. dollar has left it looking expensive. One gauge of a currency’s value is its real effective exchange rate, or REER, which measures a country’s exchange rate against several trading partners, adjusted for inflation.
  • The dollar’s REER is currently higher than both its five- and 10-year averages, according to the Bank for International Settlements. While currencies can trade above and below their long-run valuations for extended periods, it underscores the extent of the dollar’s rally.
  • Meanwhile, the real effective exchange rates for both the euro and yen are below their five- and 10-year averages, suggesting they are cheap.
  • For sure, there are other factors that could push the dollar higher this year.
  • Changes to U.S. tax policy, especially any that provide incentives for companies to bring the cash they have stashed abroad back into the U.S., could yet be a game changer for the dollar. If U.S. companies repatriate those earnings, the resulting flow of money could boost the dollar regardless of the economic outlook. President Donald Trump has talked about lowering the corporate tax rate, and his Treasury Secretary Steven Mnuchin has laid out plans to overhaul the tax code by August.
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