It may be the late innings in baseball, or the two-minute warning in football or at extra time in soccer. Whatever sports analogy you choose to describe where we are in the U.S. dollar’s years-long rally, it’s beginning to feel like the end.
About half a year ago, we suggested that the dollar rally would likely continue. In our view, we are now nearer to the end of this rally than the beginning. From this point, it will be more challenging for the dollar to see significant gains. While an imminent turn in the dollar would mean that the rally did not reach the peaks experienced during the last two bull runs, we have nonetheless experienced a strong rally over the last several years. And in many respects, this time is different.
Exhibit 1 shows the inflation adjusted (real) traded weighted dollar against “major” and “other” currencies, as defined by the Federal Reserve (see definitions below Exhibit 1). So far, the current rally has lasted five years—a shorter period than the previous two. Then again, this has been a fairly unusual cycle. In particular, this was a rather modest rally against “other” currencies, which mostly include emerging-market currencies. In fact, broadly speaking, this rally has not been nearly as significant as others—notwithstanding significant declines in select currencies that contributed to the rally.
In an environment where markets generally stabilize, the Fed continues to hike interest rates and global growth moderates, the dollar will likely continue to advance, but sometime this year we believe the dollar will be broadly priced at such a level that will stall the rally and benefit investors with short dollar positions, potentially for several years.
Scenarios That Could Lead to a Turn in the Dollar
There are a number of scenarios that could cause the dollar’s rally to turn sooner than it has historically. All have realistic potential for occurring. Several could also see some “false starts,” in which the dollar moves dramatically lower on expectations of a change in trend, yet it may take several “restarts” before a bear trend in the dollar’s value is fully established.
- Scenario #1: The Fed points to an early end of the interest-rate hiking cycle to avoid a policy mistake. In this scenario, the Fed would hike rates perhaps once more in 2016 and then realize that disinflationary trends and global economic fragilities are such that hiking further would be a policy mistake and risk a more pronounced economic slowdown. In such a case, the dollar’s uptrend would likely stall and eventually turn bearish against most, but not all, currencies. This scenario allows for differentiation of currency performance given various monetary policy and economic performance.
- Scenario #2: Reflation in Europe. In this case, the euro would be the best performer against most currencies, while the dollar would not necessarily do poorly against others. This scenario would probably not result in the broadest weakness of the dollar, but it would allow the euro to appreciate significantly against a wide range of currencies. Generally, this is a scenario in which the U.S. dollar would perform poorly against the euro, the British pound and probably the Japanese yen—but it would continues to do well against emerging-market currencies.
- Scenario #3: Actual or perceived Global growth stabilization, particularly in China. Here the dollar’s value would turn, primarily because the forces that have been weighing on emerging market currencies (particularly negative market sentiment) would reverse and cause the dollar to weaken. In this scenario, the euro and Japanese yen would likely also depreciate against emerging-market currencies, however a better global manufacturing outlook would mean positive performance of major currencies against the U.S. dollar.
- Scenario #4: The market realizes the return potential of emerging-market currencies. Many such currencies have already undergone a correction of 30% or more. This correction, combined with high carry, means that the potential return from long positions in emerging-market currencies has risen significantly. Forward foreign-exchange rates offer significant upside compared with 18 months ago due to technical factors and significant investor positions in bearish hedges. A dollar turn against emerging-market currencies could be meaningful. Yet, in this scenario, the U.S. dollar would probably move little against developed-market currencies while weakening against emerging-market currencies. The euro, Japanese yen and British pound, which have generally performed well against emerging-market currencies, would likely weaken against those currencies.
We see all of these foregoing scenarios as plausible, and a combination of several of them as most likely to cause a relatively sudden change of trend in the dollar’s valuation. For example, the market perception that the Fed will pause (scenario 1) and the stabilization of global growth (scenario 3) would likely cause the dollar to turn.
Benefits of Active Currency Management
Active management of currency positions within international fixed income portfolios becomes essential in today’s environment. The dollar may strengthen further, but should a turn occur in the near term, those who have shunned foreign currencies due to recent volatility forego a large potential source of return. Actively managing currency exposure offers substantial opportunity.
As highlighted in Exhibit 2, global government bond returns can be significantly enhanced or hindered by currency performance. Over long periods of time, the unhedged Citi World Government Bond Index has substantially outperformed its dollar-hedged counterpart. However, the dollar’s recent bull run has seen much of the return made from currencies erode to only a handful of percentage points. But, when hedged or left unhedged at the proper times, there have been opportunities to benefit from both dollar strength and weakness. We look for such opportunities if and when the dollar’s valuation begins to turn in the near future.
Currency Positioning in Oppenheimer’s International Bond Fund
Part of active currency management in the Oppenheimer International Bond Fund has been tactical. We look at which currencies move dramatically, and try to understand whether these movements fully reflect the best or worse case outcomes for a currency against the dollar or other trading partners. However, it is often the big-picture view that drives the fund’s foreign-currency allocation.
Over the last several years, the fund managers have actively decreased their foreign-exchange exposure to extremely low levels in the middle of 2015. Since that time, the team has increased exposure primarily to the euro, Japanese yen and British pound, but remains well under benchmark weights (Exhibit 3). One reason for this change is to prepare for a potential turn in the dollar trend. Recent market volatility has also seen these three currencies perform well against emerging-market currencies. Additionally, they have tended to be safe-haven currencies during times of significant market volatility and flight to quality.
Over the course of the year, should one or more of the scenarios discussed above appear to be playing out, the fund would likely increase its foreign-exchange exposure. However, should the U.S. economy improve enough for market expectations to begin moving toward the Fed’s “dot plot,” one would expect a potential resumption of the U.S. dollar rally. Within an active foreign-exchange allocation, being flexible is key to take advantage of such possible outcomes.
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The Citigroup Non-U.S. World Government Bond Index is an index of fixed rate government bonds with a maturity of one year or longer and amounts outstanding of at least U.S. $25 million.
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