Until the summer break, the newspapers had been full of stories about the declining US dollar and predictions about its end as the world’s leading currency. This debate flares up whenever there is a sustained weakness in the dollar, as we have seen in recent years. It helps to take a longer-term view, though. These cycles are not new. The dollar suffered bouts of protracted weakness in the past, like in the late seventies and in the mid-nineties, only to stage strong recoveries.
Since the end of the Bretton Woods System of fixed exchange rates way back in 1973, the value of the dollar against other major currencies has been subject to large swings. Over the past two decades those swings lasted roughly fourteen years (seven years up and then seven years down). Since its peak against the Euro back in 2001 and until July, the dollar lost roughly 50%: seven years down. Now, over the last months it has gained almost 10% from its 1.60 peak.
Are the seven down years finally over? It is difficult to say. But one thing we do know is that currencies cannot forever drift away from one of their fundamental anchors: purchasing power parity. Purchasing power parity gives an indication of where the exchange rate should be to make the price of a basket of goods in the US the same as in another country. We knew, therefore, that the cheaper that a range of US assets, including Manhattan apartments, became relative to comparable assets elsewhere, the greater the bargain for foreign investors and the greater the likelihood that the dollar would snap back at some point. Based on our estimates, the purchasing power parity between the euro and the dollar is 1.27. This means that at current levels - 1.47 – the dollar is still more than 15% undervalued against the euro. This is no longer a big enough gap to make a bold forecast for a further substantial appreciation of the dollar, but it gives a sense of why a 1.60 exchange rate (which means the dollar was 25% too cheap) was not really sustainable.
What is currently driving the euro/dollar exchange rate is the ongoing weakness of the European economy. While every market participant has known for quite a while that the US economy is in pretty bad shape, the latest economic indicators out of Europe clearly surprised the market on the negative side. Moreover, this finally shattered the belief that Europe could decouple from the US. This initiated a trend for a stronger dollar, which is still not over, because we expect even more negative news from the European economies in the months ahead.
We, therefore, favor the dollar against the European currencies over the next couples of months. We believe that currency investors are likely to be well served by using moments of temporary greenback weakness, which might occur during this period, to build up dollar positions.
