Over the past 2 years, the value of the U.S. dollar has increased significantly against the currencies of other major economies. For example, counting from the beginning of 2021 to the end of October 2022, the dollar has gained about 19 percent cumulatively against the euro and about 40 percent cumulatively against the yen. It is very rare to achieve such an appreciation in just 20 months.
why u.s. dollar getting stronger in such a short period of time?
There could be a variety of reasons behind it. For example, the dollar has always been seen as a “safe-haven currency”, that is, when the asset market turmoil, or even panic, the first thing investors think of is to exchange their currency for dollars and buy U.S. Treasuries. This factor may explain why the dollar rose significantly against nearly every other currency at the start of the Russia-Ukraine conflict earlier this year.
Another possible reason is the Fed’s greater willingness to raise interest rates, and the faster pace at which it has done so compared with other central banks. The benchmark rate for the dollar, for example, is now 3 percent to 3.5 percent, compared with 2 percent for the euro and minus 0.1 percent for the yen. In the foreign exchange market, there are many investors who are willing to participate in the “carry trade”, that is, to borrow the currency with low interest rates to buy the currency with elevated interest rates to earn the spread. Higher interest rates on the dollar compared to other currencies encourage additional carry trades and push up the value of the greenback.
So after 2 years of consecutive gains, is the dollar currently overvalued or undervalued? Is the dollar overvalued, or undervalued?
There are plenty of indications that the dollar is more likely to be overvalued. For example, The Economist magazine has a famous “McDonald’s Index”. The index collects and compares the price of McDonald’s burgers worldwide and uses it to determine whether a country’s currency is overvalued or undervalued. “An essential logic under the McDonald’s Index is the assumption that the same McDonald’s burger should be sold at the same price around the world. For example, if McDonald’s sells for $5 in the U.S. and 30 RMB in China, then the “fair” exchange rate of the U.S. dollar to the RMB should be 1 to 6. By comparing this “fair” exchange rate with the real world factual exchange rate, one can speculate whether a country’s currency is overvalued or undervalued relative to the The Economist, in its July report, said that the “fair” exchange rate should be 1 to 6. Based on the “McDonald’s Index” calculated by The Economist in July, the currencies of most of the world’s major economies are undervalued compared to the U.S. dollar. For example, the euro is undervalued by 7.5 per cent, the pound by 13.8 per cent, the yuan by 30 per cent, the yen by 45 per cent and the Hong Kong dollar by 48 per cent.
Then we look at the Real Effective Exchange Rate (RER) of the US dollar. According to the calculations of the Bank for International Settlements (BIS), the real effective exchange rate index of the US dollar is currently in the third highest position since 1970, after 1971 and 1985, and only about 5% short of the high point in 1985. In particular, in 1985, the United States, Britain, France, Germany and Japan signed the famous Plaza Agreement at the Plaza Hotel in New York City to jointly devalue the dollar. Since then, the value of the U.S. dollar began to fall rapidly against the major currencies of different countries (the Japanese yen, the German mark, the British pound, the franc, etc.). In just two years since the Plaza Accord, the dollar has lost more than 50 percent of its value against the Japanese yen and the German mark, and nearly 50 percent against the British pound and the Swiss franc. There is, of course, no indication that any government is interested in meeting to negotiate a reduction in the value of the dollar, but it is clear enough that the dollar is near an all-time high.
Looking ahead from today, it is unlikely that the dollar’s strong position will be reversed in the short term, so what does this environment mean for national stock markets? Broadly speaking, the more undervalued a currency is today, the more likely its country’s stock market is to return better over the next 3 years.
There are two main reasons behind this. First, currency movements in major economies are rarely a straight line of devaluation or wild rises, but often fluctuate around an average value. A currency that depreciates continuously is more likely to bottom out next, while a currency that appreciates continuously is more likely to top out and retrace. So a currency that is currently undervalued, even if the country’s stock market does not shift in the next few days, is likely to become more marketable as its value “reverts to the mean”. Second, the low value of a country’s currency means that the products and services it offers are less expensive, which is a major benefit to the country’s export sector and tourism, and could spur its stock market to start rallying in the next few years.
While the above is a theoretical level analysis, is there any empirical support for such a prediction? Researchers (Inker, 2022) compiled historical data on financial markets over the past 50 years (1970-2022) and found that currencies that were initially overvalued (by more than 16%) declined in value by an average of about 5.4% over the next 3 years. In contrast, currencies that start out relatively undervalued (undervalued by more than 14%) see their value rise by an average of 8.7% over the next 3 years. Then, the first conjecture, that there is a pattern of “mean reversion” in currency values, is supported by empirical evidence.
Second, the researchers also found that currencies that started with higher valuations saw their stock market returns fall by an average of about 11 percent in dollar terms over the next three years. By contrast, currencies that started with lower valuations saw their domestic stock market returns rise by an average of about 9.3 percent in dollar terms over the next three years. This pattern exists, not only in developed markets, but also in developing markets.
These findings suggest that we investors should constantly remind ourselves when analysing financial markets not to be unduly influenced by the news and price changes that are currently taking place. What is also valuable to investors is not what has happened in the past, but what may happen in the future.
In the medium to long-term, numerous assets have a “reversion to the mean” characteristic, thus don’t be overly bullish or bearish on them because of their recent price increases or decreases. For example, if we look at the returns of Japanese and European equities over the last 2 years, it is likely to give a highly pessimistic feel. However, from a value investing perspective, European and Japanese stocks happen to be in a state of “double low” currency valuation and stock market valuation. Of course, this does not mean that European and Japanese stocks will necessarily start to rally in three months, six months or a year, but at least it shows that for long-term investors such assets are worth patiently holding on to.