After more than a decade of prevailing strength in the U.S. dollar (USD), evidence increasingly suggests the currency is weakening. Long-term cyclical shifts in the dollar’s value tend to be well-defined and can last for upwards of a decade. So what’s causing the USD to weaken now? What’s the outlook and what does it mean to investors?

First, some context. Currency values are largely driven by capital flows. Trillions of dollars’ worth of currency are traded every day in the massive foreign-exchange markets. Money tends to gravitate into currencies where economic prospects are brightest, where equity markets are most attractive and where bonds offer the most yield.

The prior USD cycle lasted for 12 years, from 2011 to 2022. It involved a dollar rally that took the currency from 20% below to 30% above its fair value based on purchasing power parity. This USD strength was extended first by economic uncertainty during the pandemic and then by rising inflation that prompted the Federal Reserve’s aggressive rate-hiking cycle.

RBC GAM’s currency specialists believe this long stretch of USD strength concluded late last year and that the USD has now entered what will be a multi-year period of weakness relative to most other currencies. Since that peak, the dollar has declined by 9% on a trade-weighted basis and by more than 20% against some currencies.

The U.S. dollar tends to move in long-term cycles

Source: RBC GAM, Macrobond. Data as of June 30, 2023.

Currency valuations at the beginning and end of the dollar’s cyclical rally

Source: RBC GAM. Data as of April 2011 and September 2022. Based on purchasing power parity estimates of fair value. USTW$ = US Trade-weighted dollar, CHF = Swiss franc, NZD = New Zealand dollar, AUD = Australian dollar, CAD = Canadian dollar, GBP = British pound, EUR = euro, NOK = Norwegian krone, SEK = Swedish krona, JPY = Japanese yen.

What’s behind the USD’s decline?

A few major factors explain USD’s weakness over the past nine months and underpin our view that it will weaken further:

• Trade and budget deficits. The U.S. has run budget deficits for decades, spending more than it earns to fund huge social security expenses (2.8 trillion per year), Medicare programs (1.5 trillion per year) and military spending (0.8 trillion per year). Meanwhile, Americans consume more foreign goods each year than the country ships out in exports. Combined, these so-called ‘twin deficits’ amount to some 10% of GDP. This represents an unsustainable policy mix, even if the USD is in demand from international businesses conducting trade and governments wishing to hold foreign-exchange reserves as protection against economically damaging exchange rate fluctuations. Increased borrowing and rising interest rates mean the cost of servicing debt is rising. This in turn raises the budget shortfall and leaves fewer resources that can be directed to productive areas of the economy.

  With this in mind, investors may start questioning whether the currency should be trading so strongly. Recent news about the difficulty in raising the debt ceiling in the U.S. hasn’t boosted confidence in the ability of politicians to reign in deficits.

  Long-term relationship between the twin deficits and U.S. dollar

  

  Source: RBC GAM, Bloomberg. Data as of June 30, 2023.

• U.S.-centric banking stress and associated economic underperformance. The failure of Silicon Valley Bank and a handful of other U.S. regional banks raised fears of further weakness across the country’s banking sector. While these concerns appear to have ebbed, the effects of these failures could persist for many years. Many small and medium-sized companies, the heart of the U.S. economy, depend on U.S. regional banks for loans. Fewer banks, or banks with balance sheet issues, mean tighter lending conditions may persist for an extended period of time. This in turn weighs on economic activity and could result in a slower pace of growth in the U.S., pushing the USD’s value lower.
• How the path of interest rates may evolve in the future. The Federal Reserve raised interest rates rapidly in 2022 in response to persistently high inflation and expectations that risked becoming unanchored. So did the Bank of Canada. Other developed central banks like the European Central Bank (ECB) and Bank of England (BofE) are further behind. Rate hikes in these regions are expected to outpace North America over the coming months, aligning interest rates more closely and helping boost the value of currencies like the euro at the expense of the USD.

  The Federal Reserve is closer to the end of its rate hiking cycle than other central banks

  

  Source: RBC GAM, Bloomberg. As of June 30, 2023.

• De-dollarization. This term refers to the gradual move away from the USD as the main currency for global trade and investment. This has prompted discussions on whether the USD will continue to be the world’s primary reserve currency – the currency that other countries and international businesses most often hold and use for trade. While this process may take longer than the anticipated multi-year decline in the USD, it could act as a continued source of pressure on valuations. It typically takes decades for a new reserve currency to emerge. However, China’s push to loosen currency controls and develop and enable access to its financial system suggests it’s making progress.

  The current move toward de-dollarization has been accelerated by several factors. These include the G7 sanctions on Russia, news that several countries (such as Brazil and Argentina) are looking to abandon the dollar in their trade, and reports which suggests the dollar has lost share in global foreign exchange reserve portfolios.

Near-term strength in the USD is possible should a deeper-than-expected recession occur. During times of economic and market uncertainty, investors flock to the safety and security of U.S. treasuries, and the associated buying of U.S. assets tends to support the USD.

However, these knee-jerk reactions are often short-lived, and would be especially fleeting this year given that the USD is trading at such lofty levels. From current levels of USD overvaluation, history suggests that we’re likely to experience an extended period of weakness that would have the dollar decline significantly from extremely expensive to below fair value.

Five strategies for investors

1. Apply currency hedging to fixed income exposure: Currency moves tend to be very rapid and volatile. Hedging aims to help investors reduce the effects of currency fluctuations on investment performance. Any meaningful currency exposure left unhedged tends to dominate the performance of the portfolio. This currency effect is particularly noticeable in fixed income funds because bonds tend to be less volatile than currencies.

   A study of unhedged exposure of global sovereign fixed income portfolios between January 1985 and March 2023 showed that currency moves were responsible for 91% of monthly fluctuations. Over that 38-year period, investors choosing to hedge currency exposure achieved annual returns similar to that of unhedged portfolios, while experiencing more stable performance.

   This data suggests two things:

   • Hedging currency exposure is always important for fixed income investors.
   • Hedging is even more crucial for Canadian investors buying U.S. bonds when the USD is expected to decline.

   Historically, a hedged fixed income portfolio has delivered more consistent returns

   

   

   Source: RBC GAM, Citigroup. As of May 31, 2023.

2. Consider emerging market (EM) bonds: When the USD declines, EM bond spreads tend to tighten. Spreads represent the difference in yields between EM bonds and U.S. government bonds. Investors tend to benefit from stronger performance when the gap shrinks. That’s because a falling USD translates into lower external borrowing costs for EM countries and a lower probability of default. With higher yields than U.S. or Canadian government bonds, EM debt offers additional return potential for investors – and a falling USD improves the likelihood that these EM bonds will outperform.

   The chart below maps the performance of the USD (tracked by the DXY index) with changing spreads of EM bonds.

   As the USD strengthens, spreads on EM bonds widen – and vice versa

   

   Source: RBC GAM, Bloomberg. As of June 30, 2023.

3. Explore international and EM equities: The USD tends to weaken as the global business cycle improves. This is because capital flows toward areas where the growth potential is perceived to be stronger. In addition, international equities often perform better during improving economic times due to their increased exposure to cyclical sectors – think consumer goods, housing and luxury goods, for example.

   Relatively attractive valuations, combined with a weakening USD, could now have international equities poised for a period of outperformance. Likewise EM equities tend to fare well during periods of USD weakness. EM companies may be supported by trade and fiscal policy as well as relatively attractive valuations.

   As global growth strengthens international equities tend to outperform

   

   Source: Bloomberg, RBC GAM. As of May 31, 2023.

4. Favour companies that earn their revenues in foreign currencies: U.S.-domiciled companies that earn revenues in foreign currencies experience a lift as the U.S. dollar weakens. Their earnings rise on a relative basis. Of course, this needs to be carefully considered as some companies may hedge their currency exposure. This could eliminate any potential benefit from the changing exchange rate. RBC GAM portfolio managers regularly consider this relationship in their portfolio construction.

   Some sectors in the U.S. have more international exposure than others

   

   Source: RBC GAM, Bloomberg. Data as of December 31, 2022.

5. Hedge your exposure to USD-denominated assets: As Canadian investors witnessed between 2002-2011 and from 2012-2022, currency moves play a large role in overall returns. If investors have unhedged exposure to U.S. equities, they may benefit from hedging their assets as the USD declines relative to the Canadian dollar. In general, investors are better served to consider these cycles as opposed to ignoring them. While the complexity of currency hedging can make it difficult for many investors to do so independently, many financial institutions, mutual fund companies and ETF providers offer solutions with built-in hedging that make it easier for investors to hedge

How the USD affects unhedged returns of Canadian investors

Source: RBC GAM, Bloomberg. Data from December 31, 2001 to December 31, 2022.

Over many decades, currency shifts tend to even out. But those with an investment horizon of only a few years may want to plan for all the ways in which their portfolio may be impacted.