One of the many surprising aspects of financial market performance over the past year has been the weak performance of the US dollar, which has fallen by close to 10 per cent on a trade weighted basis and by more than 10 per cent against the euro.
This has occurred despite a variety of factors that might have been expected to push the dollar up. They include upwards revisions in economic forecasts, expectation of monetary tightening, rising real and nominal long-term interest rates, fiscal stimulus on a huge scale in a full employment economy, rising protectionism that should choke off import flows, and tax reform directed at reducing capital outflows and increasing capital inflows.
It is instructive to consider what the combination of interest rates and current exchange rates says about market expectations of future currency values. US 10-year interest rates are about 230 basis points above German rates and about 280bp above Japanese rates. This implies that markets expect depreciation of the dollar by more than 25 per cent against its major competitors over the next decade. If dollar depreciation of this magnitude was not expected, investors would prefer dollar assets to foreign assets, given the interest rate differentials. Some but probably less than half of the dollar’s weakness can be explained by higher than expected inflation in the US. Real interest rates imply an expectation of continuing real depreciation.