Few economic questions confuse and divide the profession more than determining what determines exchange rates. In the days when floating exchange rates appeared awkwardly after the collapse of the Bretton Woods system in the early 1970s, an extremely confident economic profession produced a plethora of papers, theories, and empirical models purported to explain the currency movements. Some work has focused on relative valuations (such as purchasing power parity), some on relative interest rates, and some on external balances as drivers of exchange rates. Others have attempted to combine the three factors (fundamental equilibrium exchange rate). The models became more and more elaborate as economists tried to explain quirks, such as the tendency of exchange rates to exceed what their model said to be “fair value.”
On the sidelines, the “technicians” of the market smiled at the appalling results that economists delivered in explaining historical changes in currencies, not to mention forecasts. Their smirks turned into frowns when their own efforts to explain and forecast exchange rates using waves, patterns, support and resistance levels and many more turned out to be equally fruitless.
While some economists remain attached to the puzzle, it wouldn’t be an exaggeration to say that the profession has all but given up, offering the default option of currencies to follow a “random walk.” This in itself seems an inglorious step back, as other asset prices remain a fair game for the theories and models that don’t end up supporting the results of the random walk.
I spent many hours and many classes in graduate school exploring the mysteries of exchange rates, to the point of writing a thesis that my board of directors sort of accepted. I sure didn’t break the currency code, but when I finished I was more than willing to admit that when it came to determining the exchange rate I knew a lot more about what didn’t work than what worked.
Having said that, I wasn’t so scared by the experience that I avoided giving a few glimpses and even dared a few predictions.
Which brings me to today’s topic: Are the days of the US dollar numbered?
The question arises because the dollar has slipped over the past month in the world’s forex markets. Of course, recent movements are not very important. Since mid-June, the dollar has fallen 1.6% against a broad basket of currencies, and just over 2.0% against the euro, and has experienced mixed performance against various emerging currencies. That said, the dollar is trading near its two-year low against the euro and has lost some 7.5% against the single European currency since mid-March.
Something seems to be happening, but what is it? Conventional models seem stuck. Despite aggressive easing by the Fed, interest differentials remain positive for the dollar. The recession has caused a massive drop in US imports and, usefully, the US external deficit has contracted as a percentage of US GDP since 2016. Expected inflation differentials are also unlikely to change much between the US and the United States. ‘Europe.
On the contrary, the signs of a recent response to the depreciation of the dollar lie in the relative growth rates of GDP and in the relative returns on assets.
For example, there is little doubt that the economic outlook for the remainder of 2020 and possibly 2021 depends on tackling the pandemic. The United States, unfortunately, seems to have virtually lost control. It certainly doesn’t show the persistent flattening of the curve across much of Europe and Asia. Is it a coincidence that the dollar recently started to sag from mid-June, when cases of Covid-19 in the United States started to increase?
In a short time, the dollar could also suffer from changes in return expectations, particularly in global equity markets. The profitability of American companies, in large part thanks to the 10-year American bull market, is now in question. The share of profits in GDP, a good indicator of corporate profit margins, has been declining for several years. A Democratic sweep in November, which polls seem increasingly likely, would lead to higher corporate income taxes and an impact on after-tax corporate profits. Economic weakness linked to Covid-19 would also hurt corporate profits. At the same time, more sustainable economic reopening in Europe or Asia should boost the profits of their companies.
If the United States abandons its leadership in global equity markets, the dollar is also likely to weaken.
Finally, the much-vaunted American economic model, with its free market ideology, flexible workforce and robust financial sector, may well have also reached its peak. The challenges come fast and furiously, posing fundamental questions about equal outcomes and opportunities in an economy that is increasingly seen as win-win, too dependent on debt, environmentally unsustainable, and unable to. generate large-scale productivity and standard of living gains. If the US political economy moves further away from unfettered capitalism, doubts about its ability to consistently generate above-average returns will erode the dollar’s long-term attractiveness in global currency markets.
Currencies are fun things, unless you try to predict them. They may well be unpredictable in the short term, but over time their core value reflects the fundamental strengths or weaknesses of the issuing country. The dollar has long been king – perhaps, as some pranksters might believe, in the land of the one-eyed – but its reign has not been so suspect for a long time. The days of a strong dollar seem numbered.
Larry Hatheway, former chief economist at UBS and GAM Investments, is co-founder of Jackson Hole Economics.