United States

Stronger dollar to define remainder of decade

THE REAL ECONOMY  | 

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The 22.3 percent rise in the value of the real trade-weighted U.S. dollar index during the past few years (half of its rise has occurred in the past eight months) is the result of changing global economic dynamics that aren’t likely to abate anytime soon. The underlying causes of the rapid appreciation of the greenback are linked to evolving energy dynamics, trade, monetary policy and economic expectations about the direction of the U.S. economy relative to rest of the world. The strength of the dollar is not a short term phenomenon. In fact, it is likely to prove to be the defining economic characteristic of the remainder of this decade.

These changes will present near-term challenges for middle market firms (see Currency Volatility May Bring Unwelcome Surprise for Some Firms). Periods of adjustment in global economics always carry asymmetrical distributional costs that are primarily borne by firms with significant exposure to foreign demand. However, over the medium-term a strong dollar will result in cheaper commodities which, complemented by a reduced cost of production associated with lower energy costs and greater purchasing power for U.S. consumers, will result in a stronger U.S. economy.

Middle Market Insight: Given rapidly changing global economic conditions, middle market firms might want to consider approaching the purchase of effective hedges against currency volatility in the same way households purchase auto, homeowners, life or rental insurance. It’s a necessary expense that one pays for with the intent of never having to use it.

Fundamental Economics

Stronger domestic demand in the United States relative to China, the eurozone and Japan on a global basis, as well as its major trading partners, Canada and Mexico, is the major reason why the greenback has soared during the past several months.

In 2014 the U.S. growth rate was 2.5 percent on a year-ago basis, above the long-term trend of 2.1 percent. Compare that with the 0.9 percent rate of growth in the eurozone, a minus 0.5 percent contraction in Japan, 0.7 percent growth in Mexico and 1.9 percent growth through November in Canada, not to mention the rapid slowing of growth in China.

A look forward at expectations for 2015 through 2018 suggests that story isn’t likely to change much. Growth in the United States is expected to be near 2.7 percent versus negligible growth in both the eurozone and Japan. Meanwhile, China will likely slip below the 7 percent growth rate which signals recession in that economy. Canada is expected to see growth around 2.2 percent and Mexico near 3.3 percent during the next two years, but both of those expected growth rates are overly dependent on a rebound in global oil prices. Should oil prices remain below the five-year average of $101.56 and the 10-year average of $86.81, there is a risk of much slower growth among America’s primary trading partners. As a result, there is some risk for even further dollar appreciation.

U.S. dollar strength poised to continue

Source: RSM, Federal Reserve

Rate and Inflation Expectations

Those growth dynamics provide a fairly stable backdrop for the continued policy divergence among the major central banks. With the U.S. growth rate well above its long-term trend, an effective policy rate of zero percent is no longer appropriate, which is why the Federal Reserve is moving to prepare global investors for the beginning of its long-awaited rate hike campaign, probably in June or September.

Remember, the Fed is doing this just as the European Central Bank is preparing to purchase about €1.3 trillion in assets, the Bank of Japan is continuing with its open-ended quantitative easing program and the People’s Bank of China is easing lending requirements and taking other unorthodox steps to bolster a sagging Chinese economy that needs to produce 10 million jobs a year just to accommodate those entering the labor force.

That policy divergence has helped shape the interest rate and inflation expectations that are now firmly aligned with continued U.S. dollar strength. Although rates will remain historically low in the United States, a quick look at the differences in the benchmark yields in global finance – the United States, German and Japanese 10-year yields that – is revealing. The U.S. 10-year yields 2.1 percent compared with .367 percent in Germany and .391 percent in Japan. This means only the U.S. provides a real rate of return after adjusting for inflation.

With the nearly 60 percent decline in the cost of oil distorting prices across the global economy, it would be a mistake to confuse disinflation in the U.S. with the outright deflation occurring in the eurozone and Japan. Once a floor is found for oil prices, inflation will stabilize and begin moving back toward its long-term average. The Fed’s preferred rate of inflation when making policy – the core PCE – stands at 1.6 percent on a year-ago basis despite the decline in oil prices. This contrasts with the deflation in the eurozone, which is linked to austerity policies imposed at the height of the 2010-to-present sovereign debt crisis. 

Trade Dynamics and Oil

The positive supply shock to global oil markets caused by the combination of the hydraulic fracking revolution and a behavioral shift in U.S. demand isn’t likely to fade anytime soon. Total daily production of oil is up 68.4 percent during the past five years, with the bulk of that (59.5 percent) occurring within the past three years. On a population-adjusted basis, miles driven by U.S. drivers are down 9 percent to 1995 levels. Total demand for gasoline on a daily basis is down 1.3 percent compared to a decade ago. The combination of an increase in the supply of oil, declining demand for imported oil and the shift in production to using natural gas is dramatically altering the trade and current account dynamics for the United States. 

At this rate, within the next few years, the trade and current account deficits in the U.S. will swing to surplus. All of this underscores the prospects for U.S. dollar strength for the remainder of the decade. While the United States will face significant challenges in putting its primary budget (the budget excluding net interest owned on the national debt) on the path to balance, these improved fundamentals have bought Washington a little more time.

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