The recent equity correction temporarily halted the US dollar's decline, as investors closed short positions and sought the US currency’s “safe-haven” qualities. As equities have stabilized, the USD’s slide has resumed. On 16 February, the DXY dollar index was trading at its lowest in three years and EURUSD had regained the year’s highs, the strongest level for the euro since December 2014.
The renewed decline is despite further widening in interest rate differentials in favor of the dollar. The 2.76% gap between two-year US Treasury and German bond yields is now the widest spread since March 1997, which conventionally would be expected to drive up the dollar’s value. But while we believe rate differentials remain important, several factors are still undermining the USD:
- The growing US fiscal and current account deficits will need financing. Fiscally stimulating an economy at full employment is likely to suck in imports, widening the trade deficit and exacerbating the problem. The need to attract capital is one reason why yields are rising and could also require a cheaper dollar.
- On the capital account, because of persistent current account deficits, US external indebtedness is rising rapidly. US net liabilities are now more than 40% of GDP, a record. To help stabilize the position, we estimate a 6–10% (broad) USD depreciation is needed over the medium term.
- The dollar remains overvalued against the euro on a purchasing power parity basis, which we estimate at 1.28.
So we expect FX markets will continue to look past US-German yield spreads. We forecast EURUSD at 1.25 over three months, 1.28 over six months, and 1.30 over 12 months.
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