How High Might the Dollar Climb?

December 2, 2015

December figures to be a watershed month for the dollar, since the divergence of monetary policies is likely to become significantly wider.  That’s a hugely positive development for the dollar in theory.  In anticipation, market participants bid the dollar up slightly more than 4.0% in November against the euro and Swiss franc and between 2% and 3% upward versus the yen, sterling, and Canadian and New Zealand dollars.  There was even a gain exceeding 1.0% against the usually inertial yuan.  Despite November’s advance, the dollar remains weaker than its high for the move against the euro reached last March, and net dollar changes have been negligible against both the yen and euro since the last FX Insights essay on this site nine days ago.

Several factors may stand in the way of reaching parity with the euro or at least make that push more difficult than imagined.  For starters, the U.S. economy appears more vulnerable than it was at the time when previous cycles of a rising federal funds rate began.  An article screened here almost three months ago presented evidence on this that remains relevant for the most part.

For the dollar to sustain further appreciation from current levels, it will not be sufficient for the Fed to tighten and other central banks to ease as widely expected.  Once Fed tightening begins, the uncertainty about how well the U.S. economy can tolerate the medicine, however low the dose, will start to be revealed.  Over the 25 calendar quarters since the last recession ended, U.S. real GDP growth has averaged 2.2% per year, which coincidentally matches the on-year pace recorded in this year’s third quarter.  In the first 25 quarters following the previous recession that ended in 4Q01, growth averaged 2.6% per year, and that was down from 3.6% and 4.8% per annum achieved during the 25 quarters after even earlier recessions that ended in 3Q91 and 4Q82.

There are four other potential dollar negatives.  First, U.S. officials with increasing frequency are already expressing concern about the dollar’s stronger levels.  Atlanta Fed President Lockhart, an outspoken proponent of raising interest rates now, also worried aloud that the dollar may become overvalued, and the Fed Beige Book released Wednesday listed the stronger dollar as one of the factors hurting the  manufacturing sector.  When the will of officials and market participants are in conflict regarding a currency’s appropriate level, it is generally easier, as is the case now, for officials to prevail when their desire is to cap strength rather than lend support.

Terrorism on U.S. soil is a second potential impediment for the dollar.  The U.S. currency can benefit from a flight to safety when terrorism hits other countries.  It would be a different matter if a series of incidents happened in the United States.  Make no mistake, U.S. economic growth since the 9-11 attacks over fourteen years ago has been quite a bit weaker than had that atrocity or others like it never occurred.  A response to terrorist threats is unavoidable but nonetheless depresses the potential growth rate.

The third possible headwind against dollar appreciation is the 2016 election, where the choices couldn’t be more divergent on just about every imaginable policy area from foreign policy to climate change to health care to tax and spending priorities and even including something so basic to currency health as guaranteed central bank independence.  The problem here isn’t just the diversity of potential policy directions but the extreme uncertainty over who will win the election.  In this era where uncertainty of one sort of another looms at every turn, the identity of the next U.S. federal government is the mother of all unknowns.

Finally, the U.S. current account deficit has been manageable so far but could become more burdensome as the effects of dollar gains magnify.  The funding of the current account shortfall might meanwhile weaken if the troubles of China and other emerging economies get nastier.

Copyright 2015, Larry Greenberg.  All rights reserved.  No secondary distribution without express permission.

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