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Dollar-Rate Breakdown Exposes Foreign-Exchange Mystery

25 Feb 2018 2:00 pm
By Chelsey Dulaney 

Stumped by a deepening slide in the dollar, analysts and investors are scouring past periods of U.S. currency weakness for clues to what might happen next.

The U.S. currency has slumped 11% since late 2016 against its main trading partners, including a 2.7% decline this year in the WSJ Dollar Index. That is surprising many on Wall Street, where dollar strength has been anticipated as a series of Federal Reserve interest-rate increases has expanded the yield premium on U.S. Treasury notes over comparable securities such as German bunds.

This yield gap typically is one of the strongest determinants of dollar performance, as higher yields tend to draw capital into the higher-yielding government bonds. That frequently pushes up foreign-exchange values in a cycle that often benefits the higher-yielding currency, as was seen in the years after 2011 when the dollar sharply appreciated at a time of improving U.S. growth.

But it isn't working this time around. On Friday, the U.S. 10-year Treasury had a yield of 2.87%, compared with a yield of 0.66% on a comparative German bond. The difference, or spread, between those two yields last week reached its widest since the start of 2017, which was just after the spread hit an all-time high.

What's going on? Some analysts say the dollar is still expensive relative to other currencies even following its recent decline, while others say economic growth in Europe, Japan and emerging markets appears poised for a larger pickup than in the U.S. Others point to parallels with previous periods of dollar weakness, while stressing that those comparisons are made loosely because many economic, political and market dynamics in prior periods won't apply to this one and vice versa.

Whatever the narrative, it is clear that investors expect the dollar rout to get worse. Hedge funds and other speculative investors are holding roughly $8 billion in bets against the dollar, according to Commodity Futures Trading Commission data, and $19 billion in bets that the euro will strengthen.

"People are a bit unclear about why the dollar is not benefiting from U.S. yields that have been moving up so fast," said Sireen Harajli, a foreign-exchange strategist at Mizuho Bank. "I think that's because of concerns about the U.S. budget deficit."

Analysts at Capital Economics say the dollar's current slide "is reminiscent of the mid-2000s," when the currency fell significantly even as the Fed raised U.S. interest rates. The culprit then, and perhaps now: market expectations of increasing deficits in the U.S. government budget and the nation's trade account.

Wider U.S. trade deficits have been a common thread in dollar bear markets. The dollar's sharp decline in the 1970s came as the U.S. moved from a trade surplus to a deepening trade deficit, along with the collapse of the gold standard and a decadelong battle with inflation.

In the 1980s, a seven-year dollar rally again raised concerns about the U.S. trade deficit, which was distorting trade balances in Europe and Japan. The governments of the U.S., Japan, West Germany, France and the U.K. in 1985 signed the Plaza Accord in a bid to weaken the U.S. currency.

There are pluses to the dollar's decline. Its strength in recent years weighed on exports by making U.S.-made goods less competitive abroad, hitting corporate profits at multinational firms. A strong dollar also can threaten emerging market economies by making their dollar debts more expensive to pay back.

"Falls in the value of the dollar oil the wheels of the global financial system, boosting global liquidity by strengthening balance sheets and alleviating currency mismatches," said analysts at Oxford Economics in a research note.

Benn Steil, director of international economics at the New York-based Council on Foreign Relations, thinks comparisons to past dollar bear cycles are of little use because of idiosyncratic factors in each period. Though the link with interest rates has broken down lately, he still believes higher U.S. rates will become a main driver of the dollar this year.

"The markets have been extremely sensitive in the past 10 to 15 years to relative interest rate differentials," he said. "All else being equal, I would expect this to be a good year for the dollar."

Write to Chelsey Dulaney at Chelsey.Dulaney@wsj.com

(END) Dow Jones Newswires

February 25, 2018 09:00 ET (14:00 GMT)

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