Should Investors Continue to Underweight the US Dollar Relative to Other Major Currencies?
Yes. We continue to expect the US dollar to weaken relative to other major currencies over the next several years. The dollar remains expensive by historical standards, and over multi-year horizons that starting valuation has usually mattered more than the shorter-term narratives that can keep currencies misaligned for a time. Recently, these narratives have included the Iran War and US artificial intelligence (AI) leadership, which have supported the dollar through firmer growth and rate expectations, in addition to continued inflows into US assets. We do not believe that these factors will provide indefinite support to the dollar, however. War-related support should fade while capital markets inflows look vulnerable due to substantial concentration risk, elevated valuations, and an evolving geopolitical landscape. Investors should therefore continue to underweight the dollar relative to other major currencies over a three- to five-year horizon.
The dollar had already begun to weaken last year and into early this year as its rich valuation, softer relative growth expectations, and growing unease with US fiscal and foreign policies weighed on sentiment. The Iran War then gave the dollar a lift by raising energy prices and increasing uncertainty, which prompted markets to reprice central bank policy paths. Until recent days, markets had been increasingly looking past the war in the Middle East. Although oil prices fell, the dollar retained its gains from that period and remains 3.7% above its pre-war level. Interest rate differentials have provided the clearest support for this dynamic. The Federal Reserve helped calm fears that it might drift toward an unduly dovish stance, and markets now price in a little more than two rate hikes by early next year. That shift has lifted the dollar back above the range it had traded in over the last year. We do not expect much more from this channel. While US core inflation is above target, wage growth continues to moderate, oil prices are well below recent highs, and the broad data do not point to a renewed inflation cycle. At the same time, a firmer macro and policy backdrop in Japan and Europe, aided by lower energy prices and fiscal spending, should make the external environment less supportive of the dollar over time.
Read the rest of the publication here.