We remain bearish on the U.S. dollar, with our outlook premised on long-term headwinds. A combination of major factors should cause the dollar to decline over the next several years: the currency’s overvaluation, a reversal of capital inflows and the erosion of U.S. fiscal credibility. We expect the early beneficiaries of such dollar weakness to be the euro and the Canadian dollar, while the yen and British pound lag. Emerging-market currencies may initially be held back by central-bank rate cuts but will eventually be buoyed by widespread weakness in the greenback.

One might have predicted that the U.S. dollar would fluctuate more than it has over the past three months given the emergence of Donald Trump as the front-runner in November’s general election, the belief that central banks are done hiking interest rates and an emerging consensus that the global economy will avoid recession. The greenback has, however, traded in a tight range for most of the past year. While the dollar remains roughly 9% below its 2022 peak on a trade-weighted basis (Exhibit 1), the lack of any follow-through, we think, is the result of offsetting factors that have kept the currency pinned in place. Recent developments, including stronger-than-expected economic growth, have supported the greenback, undercut by longer-term factors such as the currency’s rich valuation.

Exhibit 1: U.S. dollar still below 2022 peak

Note: As at February 29, 2024. Source: Bloomberg, RBC GAM

The U.S. dollar’s gains in the aftermath of the pandemic have most models indicating the currency as significantly overvalued. Our preferred measure, purchasing power parity, suggests that the dollar is more overvalued than at any point since the mid-1980s (Exhibit 2), a level unjustified even after accounting for U.S. energy independence and U.S. leadership in technology.  We expect this overvaluation to be short-lived because, as with an elastic band that is stretched, resistance grows as the currency deviates from fair value. And when the snapback finally occurs, currencies tend to over-adjust and move from one extreme to the other rather than stopping at fair value.

Exhibit 2: USD – Purchasing Power Parity Valuation

Note: As at February 23, 2024. Uses new Fed USD index (USTWAFE Index) from Dec 31, 2019. Source: U.S. Federal Reserve, Bloomberg, RBC GAM

One argument why the dollar could remain overvalued in the short term is that interest rates have risen with expectations that the U.S. Federal Reserve (Fed) will reduce policy rates more slowly than had been expected late last year. The 50-basis-point increase in U.S. 2-year yields seen in February would normally cause the greenback to appreciate had it not been for the fact that German interest rates also rose. So, while U.S. yields are higher than peers’, it is the change in relative interest rates that is keeping the dollar within its range.

Investors are now pondering whether the U.S. elections in November could allow the currency to remain strong and resilient in the face of longer-term headwinds. A Trump victory would likely cause the U.S. dollar to appreciate in the short term due to the nature of his policies. For instance, a proposed 10% tariff on all imports would dent the competitiveness of the country’s trading partners by raising the price of foreign goods for American consumers. In addition, expansionary fiscal spending, tax cuts and deregulation would perpetuate the U.S.-dollar-supportive economic outperformance experienced over the past year. Trump’s disdain for international organizations and his less ardent support for Ukraine may also elevate the greenback because a withdrawal of military support would be negative for European stability.

With that said, the reaction to a Trump victory may be limited to a knee-jerk spike in the dollar similar to the months after he secured the White House in 2016 (Exhibit 3). Republican presidencies have generally been worse for the greenback, with the most negative periods being those in which both houses of Congress and the White House are controlled by the GOP (Exhibit 4).

Exhibit 3: Post election U.S. dollar rally short-lived

Note: As at February 29, 2024. Source: Bloomberg, RBC GAM

Exhibit 4: U.S. dollar’s performance under different political parties

Note: As at February 29, 2024. Source: Bloomberg, U.S. Federal Reserve, RBC GAM

We note that the dollar usually performs poorly when equities rise, and we think Trump’s penchant for deregulation and tax cuts would be positive for stock markets. He is also likely to remove support for the greenback by leaning on the Fed to keep policy rates lower than they would otherwise be, an outcome he can achieve by appointing board members if his efforts to jawbone the central bank are unsuccessful.

It is important to recognize the reasons a Trump presidency could have more bearish long-term implications for the dollar. For one, Trump’s preference for cutting taxes and keeping interest rates low threatens to further damage U.S. fiscal and monetary credibility. Tax reductions and interest-rate cuts are tools to be used in an economic slowdown, and the U.S. economy is clearly not in need of extra stimulus. A combination of monetary and fiscal easing could stoke additional inflationary pressures which, at a time when inflation is a concern, could erode the value of the greenback relative to other developed-market currencies. 

A second long-term concern involves Trump’s criticism of trade partners that run surpluses with the U.S. and his willingness to weaponize the currency to exert geopolitical influence. Both Trump and Biden have locked countries out of the dollar-based payment system for failing to comply with international law, and a second Trump term would likely lead to the more frequent use of this approach.

Trump was the first president to extend the use of this tool beyond Cuba, after Iran pursued a nuclear-enrichment program, and Biden has used the same method against Russia following its invasion of Ukraine. Biden went several steps beyond economic sanctions by effectively seizing Russian assets, so it is clear that the practice of weaponizing the dollar is not exclusive to one political party. The increasingly frequent use of the dollar as a political lever is causing holders of significant foreign-exchange reserves to question the safety and security of national savings physically held in the U.S. or denominated in U.S. dollars. The U.S. policies haven’t dislodged the greenback as the world’s primary reserve currency, but there is certainly a noticeable uptick in the amount of global trade and investment occurring in other currencies, including Russian oil exchanged for Chinese renminbi or Indian rupees.

In any case, the longer-term trajectory of the U.S. dollar tends not to be driven by elections but by persistent factors that can alter the currency’s trajectory over longer periods. Valuation is one of these anchors and is well aligned with the six- to nine-year phases between peaks and troughs of U.S.-dollar cycles (Exhibit 5). We believe the dollar is in the early stages of a long-term decline that will result in a plunge of at least 20% over the next several years. A persistent current-account deficit and large fiscal expenditures will reinforce this trend. The gradual shift away from the U.S. dollar in foreign-exchange reserves, even if only a small share of this US$12 trillion pool of capital, will also exert downward pressure on the dollar.

Exhibit 5: Long-term cycles in the U.S. trade-weighted dollar

Note: As at February 23, 2024. Source: Bloomberg, U.S. Federal Reserve, RBC GAM

This longer-term backdrop is of critical importance to our outlook as it sets the stage for how other currencies might perform. A falling dollar will be the tide that floats all other boats, as has been the case since the greenback peaked 18 months ago (Exhibit 6). We expect that the initial beneficiary of this U.S.-dollar weakness will be the euro, as the single currency is the next most important for purposes of global trade and investment, and most often counterbalances the U.S. dollar’s fluctuations. Unlike the Canadian dollar, which is likely to keep pace with the euro, we expect the Japanese yen and British pound to strengthen less as the dollar falls.

Exhibit 6: Most currencies stronger since the dollar’s peak

Note: Since September 30,2022. As at February 29, 2024. Source: Bloomberg, RBC GAM

Emerging markets

Emerging-market currencies have performed relatively well in recent years. A large yield advantage due to aggressive interest-rate hikes in the fight against inflation has supported emerging-market assets and insulated currencies from rising rates in developed markets.

Now that inflation is moderating globally, some emerging-market central banks have begun to ease monetary policy even as central banks in the developed world remain on hold. The yield gap between the highest- and lowest-yielding currencies (Exhibit 7) has shrunk rapidly as a result – a trend that could limit investors’ enthusiasm for emerging-market currencies. Greater exchange-rate volatility may have the same result as it changes the calculus on the amount of risk taken to exploit yield differences across countries. While markets have so far remained calm, forward-looking measures (option prices) suggest greater currency-market fluctuations are in the cards as election jitters play out in the second half of the year (Exhibit 8).

Exhibit 7: Narrowing gap between highest and lowest yielders

Note: As at February 29, 2024. Source: Bloomberg, RBC GAM

Exhibit 8: Markets pricing greater volatility into U.S. elections

Note: Average of the difference of historical volatilities of G9 currencies. As at March 8, 2024. Source: Bloomberg, RBC GAM

This is not to say that emerging-market currencies must weaken significantly, as they continue to offer higher yields and as the hard-won credibility of central banks in the battle against inflation continues to pay dividends. A big part of this credibility comes alongside a shift toward floating exchange rates, which allow central banks to focus on fighting inflation rather than managing the level of the currency.

We see other signs that should support emerging-market currencies, as these countries progress on the path toward economic development:

• Improved functioning of government and better enforcement of the rule of law.

• Greater inclusion of workers into the formal economy, which raises tax revenue and creates jobs.

• The creation of pension funds that provide a social safety net and encourage retirement savings, a pool of capital that helps governments fund themselves domestically.

• The strengthening of domestic capital markets, which encourages investment by foreigners.

Alongside these socioeconomic advances, the rising share of emerging-market assets in global portfolios has fueled demand for emerging-market currencies. We expect this demand to continue, and for emerging-market currencies to benefit from a broad decline in the U.S. dollar.

Weaker European economic activity is the principal reason the euro has failed to find its footing in recent years. The difference between economic growth on each side of the Atlantic Ocean has been stark, causing capital to leave the eurozone as the prospects for asset returns look brighter elsewhere. A cocktail of lower interest rates, meagre economic growth and geopolitical uncertainty has dented sentiment toward the currency. It can be argued, though, that investors are too bearish on the euro. The bar for economic data is now so low that recent indicators have begun to surpass expectations, and positive surprises in Europe are now outstripping those in the U. S. (Exhibit 9) – a sign that sentiment toward the single currency is due to improve. Upgrades to global growth forecasts tend to have a greater impact on currencies than do changes in U.S. growth expectations, and we expect the euro to benefit from such a shift.

Exhibit 9: Economic data surprises

Note: As at March 5, 2024. Source: Citi, RBC GAM

The pessimism embedded in the exchange rate can also be quantified by comparing the euro against some of the factors that determine the exchange rate. Whether we look at the performance of equity markets or the added yield required by investors to hold Italian bonds, the euro’s major drivers suggest the currency should be trading in the neighbourhood of US$1.17 (Exhibits 10 & 11). We think the euro can strengthen beyond these levels, and we target an exchange rate of US$1.21 within the next year.

Exhibit 10: European equities point to a higher euro

Note: As at February 29, 2024. Source: Bloomberg, RBC GAM

Exhibit 11: Peripheral spreads point to a higher euro

Note: As at March 6, 2024. Source: Bloomberg, RBC GAM

Yen

The Japanese yen has been the worst-performing developed-market currency over the past year and the second worst globally after the Turkish lira. This performance is largely a symptom of the wide gap between the Bank of Japan’s (BOJ) -0.10% policy rate and the Fed’s 5.50% setting (Exhibit 12), an opportunity cost that makes it unattractive for Japanese investors to hold their own currency.

Exhibit 12: Japanese – U.S. rate differentials at extremes

Note: As at February 29, 2024. Source: Bloomberg, RBC GAM

Another mark against the yen is the fact that the BOJ is unlikely to resume its currency intervention. The primary motivation in defending the yen late last year was to maintain the effective functioning of Japanese financial markets and to prevent disorderly fluctuations in the exchange rate (Exhibit 13). Barring another sudden depreciation in the yen to 160, we don’t think investors can count on the BOJ to limit Japanese yen losses. A broad dollar sell-off is needed in order for the Japanese yen to rally.

Exhibit 13: Bank of Japan intervention history

Note: As at January 31, 2024. Source: Japan Ministry of Finance, RBC GAM

An appreciation in the yen would also require a sustained BOJ pivot away from ultra-easy monetary policy or additional rate cuts by the Fed beyond what is currently expected. We expect both of these developments to eventually materialize, though perhaps not until later this year. A broad equity-market sell-off that reignites safe-haven demand for the Japanese currency could also help. We have trimmed our optimism on the yen and now expect the currency to hit 135 per U.S. dollar within 12 months.

British pound

The UK has experienced faster inflation with slower economic growth than its peers since late 2022. This combination would not seem to be a particularly attractive outcome for currency traders – and yet the pound has managed to consistently outperform most other developed-market peers over the past year. While the longer-term effect of the country’s structurally higher inflation (Exhibit 14) will be a gradual erosion of the pound’s value, it also means that the currency has been propped up by the Bank of England’s reluctance to cut rates.

Exhibit 14: UK has structurally high inflation

Note: As at January 31, 2024. Data since 1990. Source: Bloomberg, RBC GAM

As inflation subsides, we expect the currency to be weighed down by the lingering impact of Brexit, the UK’s twin deficits and a soft housing market. A sudden increase in outbound foreign investment is also a concern for investors (Exhibit 15) because it exacerbates the UK’s already deteriorating balance of capital flows. Additionally, the country is facing a troubling rise in health-related unemployment, with more than 2.5 million of the UK’s 67 million people out of work due to long-term disability (Exhibit 16). We remain long-term bears on the British pound and expect it to appreciate the least of the major currencies versus the dollar. Our current view is that the pound should rise only modestly to US$1.31 over the next 12 months.

Exhibit 15: UK investment flows

Note: As at September 30, 2023. Source: U.K. ONS, RBC GAM

Exhibit 16: Large part of the labour pool is out sick

Note: As at November 30, 2023. Source: Bloomberg, RBC GAM

Canadian dollar

The Canadian dollar has traded between C$1.32 and C$1.40 per U.S. dollar over the past 18 months, partly mirroring broader moves in the U.S. dollar and partly reflecting medium and long-term factors that may be at odds with each other.

Over longer investment horizons, the loonie has a lot going for it:

• The Canadian dollar is undervalued, based both on short-term and long-term models.

• There is steady foreign demand for Canadian bonds.

• The country has a strong and stable banking system, without the deposit flight or market stress seen in the U.S. last year.

• Fiscally, Canada runs smaller and more sustainable deficits than its peers (Exhibit 17)

• Canada’s increasingly well-educated workforce provides opportunity for higher-quality growth (Exhibit 18).

• Strong immigration should boost growth potential in the long term.

Exhibit 17: Canada’s fiscal balance is healthier than peers

Note: As at December 31, 2023. Source: IMF, RBC GAM

Exhibit 18: Educational attainment

Note: As at February 29, 2024. Source: Statistics Canada, RBC GAM

We continue to think that the Canadian dollar’s positive long-term fundamentals will lead to its appreciation over time, particularly against a falling U.S. dollar. But our optimism has been tempered somewhat over the past year as several developments hurt the currency’s prospects. Most notably, rising mortgage payments and rents are weighing on household consumption, an effect that becomes more pronounced each month as mortgage rates are reset higher.

The country’s immigration policy has also not delivered the economic benefit that we, alongside many others, had initially celebrated. In fact, even with substantial increases in the labour force, the size of the economy has declined on a per-capita basis, meaning that the standard of living for most Canadians has deteriorated (Exhibit 19). Unhappiness with the government’s immigration plan has emerged in response to a shortage of housing, and that opposition will undoubtedly intensify if it also results in a shortage of jobs.

Exhibit 19: Real GDP per capita suggests no improvement in Canadian living standards

Note: As at December 31, 2023. Indexed to 100 on January 2016. Source: Bureau of Economic Analysis, Statistics Canada, RBC GAM

Another explanation for the loonie’s recent weakness and the country’s ailing per-capita GDP is the reluctance of companies to invest in growth opportunities. Canada lags in key areas of investment, including spending on research and development and creation of intellectual property. Adjusted for population, patent registrations have lagged those in the U.S., China, South Korea and Japan for many years (Exhibit 20), contributing to the country’s low productivity.

Exhibit 20: Canada lags peers in innovation

Note: As at December 31, 2022. Source: Macrobond, RBC GAM

Canadian companies have shown a reluctance to make capital investments. This is understandable for the oil patch, where politics make the prospects uncertain, but it extends to the large percentage of Canadian firms that are choosing more and more to make capital expenditures outside the country rather than within it (Exhibit 21). Outbound foreign direct investment (FDI) was less of a concern in recent years because Canada’s trade deficit was contained during the pandemic. But the current-account balance has again fallen into deficit now that Canadians are travelling abroad and snowbirds are back to wintering in Florida. These steady outflows – both from FDI and from the current account – impose continuous downward pressure on the Canadian dollar.

Exhibit 21: Foreign direct investment

Note: As at December 31, 2023. Source: Statistics Canada, RBC GAM

In the meantime, investors are focused on several shorter-term themes. Canada’s sensitivity to slowing U.S. economic growth is one. A U.S. slowdown could cause the Canadian dollar to weaken toward C$1.40 per U.S. dollar, while risks of a bigger economic downturn keep foreign-exchange traders anxious about a more meaningful sell-off in the loonie. The relative stance of central banks is another concern. We suspect that the Bank of Canada is more eager to cut policy rates than the Fed given the country’s slower economic growth, higher household debt and greater sensitivity to mortgage resets.

We expect that these short-term factors may weigh on the loonie for a time – not enough to see it weaken beyond its well-established C$1.32-C$1.40 range, but enough for it to underperform the euro. Over the longer term, we expect the Canadian dollar to perform better against the U.S. dollar than its other developed-market currencies as it appreciates to C$1.27 per U.S. dollar over the next 12 months.