Immediately following the US Presidential election last year, the dollar soared to levels not seen since 2002 on the promise of “pro-growth” economic policies. The US Dollar Index (DXY), which measures the dollar against six major international currencies (in order of weight: Euro, Japanese Yen, British Pound, Canadian Dollar, Swedish Krona, and Swiss Franc), has since fallen not only to its pre-election levels, but now some 4% below. If you are planning a European vacation this month, it will be 10%+ more expensive than it would have been in January. But the dollar’s recent weakness has implications far beyond the cost of European vacations.
First let’s talk about the factors that are driving the dollar lower. Over the past several months, there has been a growth convergence between the US economy and those outside the US. Expectations for US economic growth have been revised lower as incoming economic data have been less than robust and the odds of a fiscal stimulus package from Washington have declined. If there is to be a major infrastructure bill or corporate tax restructuring plan enacted, it will not be soon. The hopes that these economy-boosting initiatives would be in place by now have been dashed.
At the same time, recent inflation data in the US have suggested that rather than working toward the Fed’s inflation target of 2%, the economy is exhibiting a disinflationary trend. Disinflation is generally not associated with a strengthening economy. The combination of lackluster economic data and lower inflation has called into question the Fed’s plans to continue raising interest rates. And though the Federal Reserve is the most hawkish of major central banks, the US central bank is already proceeding at a snail’s pace relative to past tightening cycles. Some economists now believe there are no more interest rates forthcoming from the Fed this year.
Coincident with the economic weakening in the US, European and Asian economic prospects have improved. German business confidence is at an all-time high even as the Euro strengthens and puts pressure on exports. In fact, production in Germany increased 1.2% in May, a full percentage point higher than analysts’ expectations. The outlook in Japan has similarly improved, and worries about a debt crisis in China have subsided for now.
Because capital tends to flow into countries offering the best growth and returns, money has left the US in recent months in search of greener pastures. Now, with most major economies forecasting 1.5-2% increases in GDP for the year, a continuation of the lackluster ~2% growth in the US does not look so great. The narrowing in the growth gap has brought the dollar back down from its highs.
What are some of the repercussions of a dollar that has lost close to 9% of its value over a short period of time? There are several. As the dollar has weakened, American exports have become relatively less expensive. Therefore, we would expect to see US exports increase, adding to US GDP. Likewise, a stronger dollar makes imports more expensive, which effectively makes domestically produced goods and services more competitive in the US. Each of these trends would be expected to boost economic growth in the second half of the year.
A falling dollar also supports earnings growth for US multinational corporations. For S&P 500 companies, 42% of 2016 revenues were derived outside the US. Robust earnings growth over the past couple of quarters, helped in part by a weaker dollar, has contributed to additional gains in a stock market that has appeared to be running on fumes at times. These gains are also positive for economic growth.
And lastly, a falling dollar is inflationary at a time when the Fed is trying to boost inflation. Among the prices that rise as the dollar falls are commodities, many of which are traded in US dollars on the international markets. Higher commodity prices are good for US companies that produce those commodities.
We have been saying for some time that the interconnectedness of the global markets is such that the US economy cannot “decouple” too dramatically from those of other countries. Currency fluctuations, and their effect on trade, act as natural equalizers between international markets and economies. Since 2010, exports have accounted for an average of about 13% of GDP, and imports have averaged over 16%. As such, large swings in trade, driven by currency fluctuations, can profoundly affect the pace of economic growth in any given year. So just as a strengthening dollar weighed on US economic growth in late 2014 and early 2015, the dollar’s weakness in recent months should be supportive of economic growth.