Some forecasters are confidently predicting a large further rise in the U.S. dollar against key currencies like the euro and the yen. And a few ominously warn of impending currency wars where central banks outside the United States will manipulate their currencies to gain a global trade advantage.
Not so fast. First, currency forecasting is a hazardous business. And second, even if (as widely projected) the dollar were to rise substantially, its appreciation would seem consistent with relative growth prospects, not currency management by policymakers.
The first point is a specific version of former New York Yankees manager Yogi Berra’s nearly universal warning: “It's tough to make predictions, especially about the future.” For decades, economists argued that exchange rates behave like a random walk, so that the best predictor of tomorrow’s exchange rate is today’s spot rate. Like other deep and liquid asset markets, foreign exchange markets are reasonably efficient, so spot exchange rates reflect the publicly available data on which most economic forecasts are based.
More recently, economists have argued that a very small fraction of exchange rate variation is predictable. The “carry trade” (in which investors anticipate a high-yielding currency to depreciate less than would be necessary to equalize investment returns across currencies) exemplifies this kind of predictable phenomenon. But as one would suspect, the return from such a strategy turns out to be extremely risky. Indeed, carry trades proved particularly hazardous for investors during the financial crisis of 2007-2009 when the sudden surge in demand for the most liquid assets drove low-interest rate currencies like the yen and the dollar sharply higher. As one of our colleagues puts it, the carry trade usually pays five cents a quarter (20 cents a year) – until it suddenly loses five dollars and wipes you out.
But, while U.S. interest rates are now a tad higher than in the euro area and Japan, today’s dollar optimists (and currency warriors) do not base their projections on a simple carry trade. Rather, they anticipate that improving economic growth and rising interest rates will mean that the United States is a better place to invest than other, more stagnant, parts of the world like the euro area and Japan. And the result will be large capital inflows that will drive the dollar markedly higher.
Such an outcome would not surprise us. Relatively better economic growth prospects can indeed warrant an outperformance of risky assets leading both domestic and foreign investors to bring funds into the United States. But that’s not news, so we suspect that it is already reflected in current exchange rates.
To help us think about the current circumstance, we have drawn the following four-quadrant chart. On the vertical axis, we plot quarterly changes in the 10-year yield spreads of nominal U.S. Treasuries over nominal German government bonds (Bunds). The horizontal axis depicts the quarterly percent change in the value of the U.S. dollar relative to the German currency (until 1999) and the euro (beginning in 1999). So, when 10-year Treasury yields rise relative to 10-year Bunds, the dot will be in the top-half of the chart; and when the dollar appreciates relative to the euro, the dot is in the right-hand half. Each red dot represents the change of the yield spread and the U.S. dollar during a single quarter from 1980 to 2013. The larger blue dots show the changes in the four quarters of 2014 (through November).
Quarterly Changes in Currency Values and Yield Spreads: U.S. Dollar versus DM and Euro, 1980 to 2014
The chart highlights several important facts. In the majority of the quarters during these 34 years, the changes land in either the upper-right (Quadrant I has 28% of the points) or bottom-left quadrant (Quadrant II has 35% of the points). This pattern is consistent with the idea that expectations of relative growth prospects are a frequent common driver of both yield spreads and currencies. For example, you might think of Quadrant I as associated with expectations of a relatively strong U.S. economy that raise the anticipated real return on capital, attract capital inflows and drive up the value of the dollar. Analogously, points in Quadrant III may be seen as times when expectations are for a relatively weak U.S. economy, leading to capital outflows that put downward pressure on the dollar. (Remember, when capital flows in, investors need to purchase dollars, increasing demand and driving up the value.)
Continuing, we see that over a third of the observations (21% + 16%) fall in the top left or lower right quadrants. What common economic fundamental might drive this pattern? One possibility is changes in relative inflation expectations. For example, in the late 1970s (not shown in the figure) the dollar depreciated sharply while the U.S. yield spread over Germany rose. Rising U.S. inflation fears probably contributed to this Quadrant II dollar crisis – until the Federal Reserve under Paul Volcker re-asserted monetary control and the dollar bounced back.
Finally, there is a lot of noise in this simple relationship. The correlation between changing yield spreads and the change in the value of the dollar is less than 0.3, consistent with the relatively flat regression slope depicted by the line we have drawn in the chart. The weakness of that association suggests that relative growth prospects are only one of a number of forces moving interest rates and currencies.
Returning to the current circumstance, focusing on the blue dots, we see that from a historical perspective, the 2014 experience is quite typical, suggesting that changing relative growth prospects are at least partly reflected in current exchange rates.
Even if, as forecasters anticipate, the U.S. dollar rises substantially, the outcome should hardly be viewed as the result of a currency war. Just like officials of the Federal Reserve, central bankers in Japan and the euro area aim to secure price stability. As we suggested recently, there is no evidence of a beggar-thy-neighbor effort to manipulate their currencies at the expense of U.S. competitors. Rather, with interest rates (even long term) close to the zero bound, the exchange rate has become relatively more important as a channel for monetary policy to influence the economy.
And there is little reason for the United States to complain from a trade perspective, let alone rail about a currency war. On a real, trade-weighted basis, the U.S. dollar is still about 7% below its average during the 40-plus years of floating exchange rates (see chart below). Even a rise of 18% – an event that has occurred only twice since 1973 – would keep it within a one-standard deviation bandwidth of the historical norm. At the same time, the U.S. current account deficit has dropped to around 3% of GDP, the narrowest gap (with the exception of the crisis year 2009) since 1999, when the dollar was significantly stronger.
U.S. Real Broad Trade-weighted Dollar Index (March 1973=100), 1973-November 2014
What if the dollar indeed appreciates sharply over coming quarters? The response of the Federal Reserve will be key for the economy and for U.S. asset markets. To the extent that a stronger dollar dampens inflation and growth prospects, the Fed naturally would be inclined to delay or limit the policy tightening that money markets now expect in 2015. In that sense, a dollar surge could prove self-limiting.
The bottom line: Yogi has it right. Beware currency forecasts (especially those of currency wars).