The U.S. dollar has ceded much of what it gained in the first half of the year and now sits 8% below its 2022 high. We expect the greenback to fall further in the coming months, and recent developments indicate that the more substantial drop that we have been forecasting may finally occur. We forecast that the euro will be the best performing developed-market currency versus the dollar over the next year, with near double-digit returns, and anticipate that other currencies will also benefit from broad U.S.-dollar weakness.

The dollar has kept mostly to a 5% range since the beginning of 2023 and remains expensive based on longer-term cycles (Exhibit 1). More recently, however, it appears that the conditions may be forming for a more meaningful decline as differences in economic-growth rates among countries widen, as central-bank policies diverge and as uncertainty surrounding elections emerges. We think that the dollar has much further to fall from current levels and that it will depreciate more than 20% over the next few years, and beyond its purchasing power fair value (Exhibit 2)

Exhibit 1: Long term cycles in the U.S. trade-weighted dollar

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

Exhibit 2: U.S. dollar – PPP Valuation

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

The dollar’s limited fluctuations this year reflect the offsetting impact of short- and long- term factors. On the one hand, the longer-term backdrop is one where the dollar should weaken because the currency is overvalued, the U.S. has large fiscal- and current-account deficits, and global reserve managers continue to diversify into gold and other currencies (Exhibit 3). However, the dollar has not yet weakened significantly due to short-term factors that have kept it elevated. These include relatively robust U.S. economic growth and higher yields on Treasurys than those offered by government bonds in other regions.

Exhibit 3: Reserve managers continue to diversify away from the dollar

Note: As at March 31, 2024. Source: IMF COFER, RBC GAM

Lured by these higher rates of return, investors have plowed a tremendous amount of capital into the U.S., outweighing the steady selling by reserve managers. Given the sheer size of these inflows nearly US$1 trillion over the past four quarters (Exhibit 4) it is notable that the greenback hasn’t managed to strengthen. Our impression is that the dollar’s extremely rich valuations are preventing gains.

Exhibit 4: Net portfolio flows into the U.S.

Note: As at March 31, 2024. Source: Bureau of Economic Analysis, RBC GAM

Meanwhile, shorter-term factors that have been propping up the U.S. dollar are beginning to fade. For one thing, the U.S. economy is no longer outperforming now that fiscal spending has tapered, and Citibank research suggests that the U.S. economy is decelerating more markedly than other major economies (Exhibit 5). Particular attention has been placed on the broad softening in labour markets where the number of new hires has fallen, jobless claims have risen, and wages have declined. These measures of the jobs market are important because they form half of what the U.S. Federal Reserve (Fed) considers when setting interest rates (the other being inflation). In response to softer inflation and weaker employment data, the Fed is expected to start cutting interest rates at its September policy meeting. It is not simply rate cuts that worry foreign-exchange traders, but the idea that the currency’s yield would be undermined over the next few years given the likelihood that the Fed cuts rates more aggressively than its peers (Exhibit 6).

Exhibit 5: U.S. economic data decelerating faster than other major economies

Note: As at August 31, 2024. Source: Citi, RBC GAM

Exhibit 6: Federal Reserve expected to cut more than peers

Note: As at August 26, 2024. Source: Bloomberg, RBC GAM

The appeal of the U.S dollar has also been dented by the increase in currency-market volatility. For years, investors capitalized on wide interest-rate differentials between regions by, in simple terms, borrowing a currency with lower interest rates and investing the proceeds in currencies with higher interest rates. The most prevalent example of investors exploiting this gap was the relatively high 5.5% policy rate set by the Fed and the Bank of Japan’s near-zero equivalent. Engaging in this so-called “carry trade” allows investors to benefit from quiet markets as they stand to earn that interest-rate gap in exchange for weathering fluctuations in the dollar-yen exchange rate.

An unexpected yet pleasant boon for traders in recent years came in the form of consistent declines in the Japanese yen, which boosted the trade’s total returns and propelled the popularity of the strategy. However, the yen’s 12% rally between early July and early August, the largest such move since the 2008 global financial crisis, brought the strategy’s streak to a sudden halt and put stress on other markets. Japanese stocks, for example, dropped 20% over three days, and high-yield bonds weakened. Frightened by the volatility and the yen’s rapid gains, traders will likely be more reluctant to bet against the yen and certainly won’t do so with the abandon they did in 2022. This removes an important tailwind for the dollar.

One final short-term factor cited by global investment banks as a positive for the U.S. dollar hasn’t turned out to be supportive at all. Earlier in the year, there was a prevailing belief that a Trump presidency would boost the dollar’s value, largely owing to his proposal to impose goods tariffs.

The blanket 10% tariff that Republicans hope to impose on goods produced abroad (60% for Chinese goods) would certainly be a headwind for global currencies, especially those of countries that conduct a lot of trade with the U.S. While a Trump victory may well be good for the dollar, we’ve found that, so far, the greenback’s movements haven’t aligned as was expected with the former president’s odds of landing back in the White House (Exhibit 7). Along with other investors, we were surprised that the dollar didn’t benefit following Biden’s poor performance at the first presidential debate on June 27, even though Trump’s odds of winning the election shot to nearly 70% following the debate. All the while, the greenback steadily declined – seemingly more focused on economic developments than on politics.

Exhibit 7: U.S. dollar and Trump’s odds of winning the election

Note: As at August 30, 2024. Source: PredictIt, Bloomberg, RBC GAM

The impact on the dollar of trade policy could be mitigated by other elements of Trump’s platform. Investors are rightly concerned about the former president’s assertion that he should have the final say on interest-rate moves, a direct threat to Fed’s independence that was established precisely to prevent such political interference. Trump’s running mate, J.D. Vance, has also floated the idea of intervening in currency markets to weaken the dollar and improve the competitiveness of U.S. exports. We don’t expect that such monetary or currency interference will come to pass, but it’s alarming that these ideas are even being raised in a political campaign. Finally, we note that fiscal deficits and the broader trajectory of debt levels in the U.S. look unsustainable regardless of which candidate wins the election. Projections from UBS suggest that primary balances – deficits from spending before interest on debt is even considered – are set to remain worse than 5% of GDP, even in scenarios where a split Congress constrains additional spending (Exhibit 8). While excess spending has attracted negative press and has weighed on currencies including Colombia’s and Brazil’s, it hasn’t yet caused much harm to the greenback. The dollar’s prominent position as the world’s reserve currency explains its resilience, but there is obviously a limit to the excesses that creditors will tolerate.

Exhibit 8: Forecasted deficits under different governments

Note: As at July 25, 2024. Source: CBO, UBS, RBC GAM

Canadian dollar

The Canadian dollar has risen during the recent broad sell-off in the greenback. The loonie has, however, underperformed the yen, euro and pound due to slowing U.S. growth, Bank of Canada (BOC) rate cuts and high household-debt levels.

These concerns have tempered our optimism on the Canadian dollar in recent quarters. While it is true that Canada’s close trade ties with the U.S. have allowed the Canadian economy to benefit from strong economic growth south of the border, we note a few other factors that have raised concern.

One has been a noticeable divergence in monetary policy, where the BOC has begun cutting interest rates ahead of the Fed this year (Exhibit 9). The Canadian central bank was one of the first G10 nations to reduce interest rates, and its three rate cuts this summer lowered Canadian-dollar yields, making Canadian assets less attractive than those in U.S. We think that the BOC and the Fed will reduce rates at about the same pace over the next year, so expect the yield gap to remain a headwind for the loonie.

Exhibit 9: Bank of Canada has cut ahead of the Fed

Note: As at September 6, 2024. Source: BOC, Federal Reserve, RBC GAM

Another negative for the Canadian dollar is the marked lack of interest by foreigners in Canadian stocks. The pace at which investors pull money out of Canadian equities is faster than they are investing in them, and it has been mounting for several quarters. Purchases of Canadian bonds by foreigners tend to be hedged, and so it is equity flows that usually drive exchange rates (Exhibit 10). Investor selling of Canadian assets likely reflects many of the elements that we have flagged in prior editions of the Global Investment Outlook. These include Canada’s relatively low productivity and the associated preference for Canadian businesses to expand their production abroad rather than build domestic manufacturing capacity. Concerns about stretched household finances have also been on this list, which we think is the primary factor responsible for the large build-up of bets against the Canadian dollar among currency traders (Exhibit 11). We add two additional items to the list this quarter: the recent slowing of U.S. economic data and the potential for political uncertainty given waning support for the governing Liberal Party.

Exhibit 10: Canadian equity outflows continue

Note: As at August 30, 2024. Source: CFTC, Macrobond, RBC GAM

Exhibit 11: Investors are very short the loonie

Note: As at August 30, 2024. Source: CFTC, Macrobond, RBC GAM

We are careful not to be overly focused on the negatives because the loonie gets support from other quarters. First, the Canadian currency is extremely undervalued and, like others, will benefit from the U.S.-dollar weakness that we expect. Second, Canada is in better macroeconomic shape than many of its peers, with lower fiscal deficits than many other major developed nations and a strong banking system, which we believe would be able to withstand turbulence in the event that high interest rates cause a spike in household defaults.

Overall, we are still bullish on the Canadian dollar and expect it to appreciate to C$1.30 per U.S. dollar, taking it just outside the C$1.32-C$1.40 range in which it’s been stuck for almost two years (Exhibit 12). The Canadian dollar should underperform the euro and Japanese yen, however, as those other currencies are more sensitive to the greenback’s fluctuations and as their economies and policy decisions are less anchored to slowing U.S. growth.

Exhibit 12: Loonie trading in a tight range

Note: As at August 30, 2024. Source: Bloomberg, RBC GAM

Euro

The euro, like the loonie, has demonstrated remarkable stability over the past two years, trading mostly within a narrow range of US$1.05 to US$1.10 (Exhibit 13). The resilience is noteworthy given weaker economic activity in Europe and uncertainty surrounding who would govern after snap French elections over the summer.

Exhibit 13: EUR - USD range

Note: As at August 30, 2024. Source: Bloomberg, RBC GAM

The fact that the currency couldn’t fall below US$1.05 as many analysts had expected is due partly to the euro’s undervaluation but also to the fact that investors were already so pessimistic about the single currency. This view has begun to change. The cheap euro has buoyed the region’s trade balance (Exhibit 14) and the combination of improved economic prospects in Europe and a falling dollar have encouraged a turnaround in sentiment. A resurgence in investor appetite for European stocks has also helped push the euro toward last summer’s highs of almost US$1.13.

Exhibit 14: Eurozone trade surplus

Note: As at June 30, 2024. Source: Eurostat, Bloomberg RBC GAM

Looking forward, a key element of continued euro strength is the monetary stance of the European Central Bank (ECB) in relation to the Fed. On the one hand, the single currency stands to gain from a slower pace of ECB rate cuts that is expected to materialize. However, it is also true that the eurozone’s lower economic speed limit doesn’t justify interest rates that match those in regions with structurally higher levels of economic growth. The arguments are largely offsetting, and so we expect the euro’s status as the primary dollar alternative to make the euro the biggest beneficiary of the dollar’s broad-based decline. Our forecast is for the single currency to reach US$ 1.21 within 12 months.

British pound

The British pound has been the best performing of the 10 major currencies over the past six months. Contributing to that stronger performance are a number of factors:

Favourable economic indicators such as stronger purchasing managers’ indexes, which measure business sentiment, have been rising since late last summer. We had expected weaker economic data from the UK through softer trade and consumer spending (due in part to mortgages resetting at higher rates), but strong business investment has buoyed GDP growth.

The UK has the highest rate of underlying inflation of the four major developed economies (Exhibit 15), and this slower progress in moderating price gains forces the Bank of England to keep rates higher and supports the currency by luring investors with more attractive yields.

Exhibit 15: Inflation stickier in the U.K.

Note: As at July 31, 2024. Source: BoC, Eurostat, U.K. ONS, BLS, RBC GAM

The UK’s core balance deficit – a combination of the current-account balance and foreign direct investment (FDI)  ̶  has undergone notable improvement over the past year (Exhibit 16). A significant reduction in FDI outflows indicates that UK firms are slowing the pace of their investments abroad. The recent election of the UK Labour Party is generally viewed positively by investors, and the party’s desire for a closer economic relationship with the eurozone would likely further improve the UK’s net balance of foreign assets and liabilities.

Exhibit 16: U.K. core balance improving

Note: As at January 31, 2024. Source: U.K. ONS, RBC GAM

On the other hand, we note that long-term factors are less supportive for the pound than for many other developed-market currencies. Sterling is not as undervalued as the euro, the currency of the UK’s main trading partner, for instance, and the UK scores among the three worst behind the U.S. and Italy on RBC GAM’s fiscal scorecard (Exhibit 17). We expect the pound to rally to US$ 1.35 but expect it to rise less than other major developed-market currencies.

Exhibit 17: Fiscal health

Note: 2023 data (IMF forecast for 2029 used as proxy for “normal”). Source: IMF, Macrobond, RBC GAM

The yen

The yen climbed 7.6% in the three months ended August 31, 2024, making it the best performing developed-market currency during the period (Exhibit 18). The yen’s appreciation was driven primarily by the unwinding of the carry trade during a period when U.S. interest rates fell and the Bank of Japan (BOJ) was the only major central bank to raise its benchmark rate.

Exhibit 18: Yen has outperformed G10 peers

Note: Performance since May 31, 2024. As at August 30, 2024. Source: Bloomberg, RBC GAM

The currency was also supported by Ministry of Finance intervention - official purchases of yen aimed at arresting its 60% slide over the past three years. In an effort to achieve maximum impact, the ministry timed its sales of foreign-exchange reserves to catch investors off-guard in holiday-thinned markets. The yen’s persistent strength since then suggests that policymakers’ actions, which started with intervention, have been sufficient to reverse the trend. Investors’ newfound reluctance to short the yen stems partly out of fear of further currency intervention but also because Japanese yields are rising relative to global peers. With an improving economic outlook and Japanese wages rising at their fastest clip in many years (Exhibit 19), we think that additional yen-supporting rate hikes are likely over the coming year.

Exhibit 19: Wage growth in Japan has accelerated

Note: As at June 30, 2024. Source: Japanese Ministry of Health, Labour & Welfare, RBC GAM

Other longer-term factors suggest further gains for the yen. Even after the yen’s recent surge, the currency ranks as the cheapest in the world on a variety of valuation models and benefits from persistent current-account surpluses driven by income earned on overseas investments (Exhibit 20). It is notable that Japanese investors own significant foreign assets, including in the U.S., that would decline in value if the greenback weakens. We would not be surprised to see Japanese investors either repatriate foreign holdings or resort to using currency hedges to protect foreign investments from further yen appreciation. These types of transactions, which involve the use of forwards contracts, tend to create additional demand for the yen.

Given these recent developments, we expect the yen to rise further and reach 130 per U.S. dollar within the next 12 months.

Exhibit 20: Persistent current account surplus benefits the yen

Note: As at March 31, 2024. Source: Bloomberg, RBC GAM