The U.S. dollar has remained elevated for longer than we had expected. Elements that were supportive of the greenback are starting to fade, however, and there are signs that fiscal concerns and a slowing economy have started to weigh on the currency, which sits more than 20% above fair value. As this process unfolds, we forecast that the dollar will weaken against major currencies such as the euro and Japanese yen. We are relatively more cautious on emerging-market currencies in the short term, though they are likely as a group to benefit over the longer term from a persistent decline in the U.S. dollar.

The U.S. dollar rallied 7% between July and October (Exhibit 1), recording its high for 2023 in early October and reinvigorating the debate about whether the greenback could continue to strengthen. Even before the rally, the dollar was extremely overvalued. Purchasing-power-parity (PPP) models indicate that the currency is 21% rich on a trade-weighted basis (Exhibit 2) and the overvaluation persists relative to most currencies. However, many of the factors that had recently propped up the dollar are fading. Among these was demand linked to the pandemic, as investors sought the safety of high-quality U.S. assets. Also bolstering demand for the greenback were relatively high interest rates after an inflation scare prompted the U.S. Federal Reserve (Fed) to hike interest rates by more than other developed-market central banks. These factors have dissipated meaning today’s lofty levels will be hard to maintain. We believe that a 10%-20% decline in the greenback within the next year or two is much more likely than a rally of similar size.

Exhibit 1: The U.S. dollar rallied in the fall of 2023

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

Exhibit 2: USD – Purchasing Power Parity Valuation

Note: Uses new Fed USD index (USTWAFE Index) from Dec 31, 2019. As at November 24, 2023. Source: U.S. Federal Reserve, Bloomberg, RBC GAM

Recent events and the currency’s November decline corroborate this view. The dollar fell 3% in November in response to a number of new developments:

• Weaker U.S. economic data. Unexpected softness in the labour market, consumer spending and industrial production hint that the miraculous outperformance gap of the U.S. economy over its global peers is likely to narrow.
• Increased investor focus on fiscal policy. The threat of another government shutdown in early November as well as debate over support for Israel and Ukraine have brought U.S. fiscal policy into the limelight. A decade of unrestrained spending and tax cuts have added considerably to the U.S. debt load and, alongside higher interest rates, the cost of financing this debt has skyrocketed in 2023. Annual interest costs have risen above US$1 trillion (Exhibit 3) – a level so obviously unsustainable that investors have become wary and rating agencies look poised to again downgrade the country’s credit rating, denting perceptions that U.S. bonds are the safest securities around.
• Chinese fiscal stimulus. Investor expectations of economic activity in both Europe and China are severely depressed. Chinese policymakers now seem intent on supporting the economy by loosening monetary and fiscal conditions, actions that could stem the decline in growth and surprise pessimistic investors.

Exhibit 3: U.S. interest payments are going parabolic

Note: As at September 30, 2023. Source: U.S. Bureau of Economic Analysis, RBC GAM

For investors to truly embrace the U.S. dollar sell-off, however, they will need to see greater economic momentum in the rest of the world rather than simply a less severe slowdown. While it’s true that a weaker U.S. economy will dampen prospects for the dollar, the direction and magnitude of changes in the greenback are driven to a greater extent by economic conditions outside of the U.S. (Exhibit 4). The dollar tends to weaken more when the global economy accelerates because economic optimism draws capital away from the U.S.

Exhibit 4: Average weekly performance of the U.S. dollar

Note: Uses quarterly data since 2002. As at September 29,2023. Source: J.P. Morgan, RBC GAM

Another important consideration for foreign-exchange markets is the trajectory of bond yields. Currencies tend to take their cue from relative yields as regions offering higher interest rates are more likely to attract investments. The U.S. dollar has been the beneficiary of such capital inflows thanks to aggressive interest-rate hikes by the Fed, which made the U.S. one of the highest-yielding regions among developed nations (Exhibit 5).

Exhibit 5: U.S. yields among the highest in the G10

Note: As at November 27, 2023. Source: Bloomberg, RBC GAM

Looking a bit more closely at the slope of the yield curve – the difference in yield between long- and short-maturity bonds – offers further insight into how currency markets might behave. Aggressive Fed hikes over the past year caused the short end of the curve to rise, an environment usually referred to as a “bearish flattening.” When short-term yields rise enough to invert the yield curve as happened in mid-2022, markets anticipate that the Fed has gone far enough in tightening policy and that a recession is on its way. What typically follows, as shown in Exhibit 6, is a “bull steepening” environment – a fall in the front end of the curve as central banks scramble to ease policy.

Exhibit 6: U.S. yield-curve regimes

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

With the Fed widely seen to have completed its rate-hiking cycle, we expect such a transition in the bond market. This shift supports our bearish view on the dollar, as bull steepening has been found to be the most negative environment for the greenback (Exhibit 7). While investors are likely to demand higher long-term interest rates to compensate them for the deteriorating credit risk associated with high fiscal deficits, it is typically shorter-term yields that are more influential in driving capital flows in the massive US$7-trillion-per-day currency markets.

Given the extent to which emerging-market currencies have already strengthened, we expect that major developed-market currencies will be the main beneficiaries of the dollar’s initial slide over the next year. We expect emerging-market currencies to resume their rise once the U.S.-dollar bear market becomes entrenched and global economic growth establishes a firmer footing.

Exhibit 7: U.S.-dollar performance in various curve regimes

Note: As at November 24, 2023. Source: Bloomberg, RBC GAM

Emerging markets

Emerging-market currencies have held up much better than most investors had anticipated in the wake of the Fed’s aggressive pace of rate hikes over the past 18 months. The group has delivered total returns of 18% since the U.S. dollar peaked in September 2022, outperforming G10 currencies by an average of 8 percentage points (Exhibit 8). The stronger gains are largely attributable to higher yields in developing economies as emerging-market central banks raised rates even more aggressively than the Fed. Real yields, the rate of interest after accounting for inflation, look especially attractive for investors now that emerging-market inflation has ebbed. While investors shied away from emerging-market currencies over the summer, the capital shifts would likely have been much worse without the draw of positive real yields.

Mindful of inflation, emerging-market central banks have been especially sensitive to currency weakness that could further raise the price of imported goods. In addition to keeping interest rates elevated, many have also propped up their currencies through direct purchases. Several Asian countries, among them some of the largest holders of U.S. dollars, have used their influence to prevent disruptive currency weakness. These actions have had a stabilizing effect on the overall currency market and have limited the extent to which the greenback could strengthen.

Additional positives for emerging-market currencies include the fact that exchange rates already factor in significant geopolitical risk, that U.S. yields have room to decline, that lower oil prices help energy importers and that the market is already positioned defensively.

There are reasons why investors may temper their optimism on emerging-market currencies. These include softer global economic growth and the valuations that are no longer as cheap as they were in the middle of 2021. We also observe that several emerging-market central banks have begun to signal rate cuts, which could threaten the yield advantage that has been one of the main pillars of support for emerging-market currencies.

So, while we expect U.S.-dollar weakness to benefit emerging-market currencies in the longer term, our view has become more balanced in the short term. We suspect that emerging-market currencies may lag their developed-market peers as soft U.S. economic growth initially pulls the greenback lower. However, as the U.S.-dollar bear market becomes entrenched, emerging-market exchange rates will again gain momentum.

Exhibit 8: Developed- and emerging-market currency performance

Note: Data since September 28, 2022. As at November 28, 2023. Source: Bloomberg, RBC GAM

Euro

Europe’s macroeconomic problems are plain to see: two wars on its doorstep, a slowing economy and the threat to energy stockpiles if this winter proves to be a cold one. The relatively quick drop in prices for goods and services (Exhibit 9), while good for the consumer, may also offer a challenge for the single currency because it raises the likelihood that the European Central Bank (ECB) could cut rates sooner than the Fed. It’s for these reasons that investor sentiment toward Europe has soured.

Looking a bit more closely, though, we see that key metrics of business sentiment including purchasing managers indexes have stabilized – a sign that the worst for Europe may have passed. Moreover, economic surprises suggesting a firmer economic outlook are also occurring more frequently in Europe these days in contrast to similar U.S. data (Exhibit 10). The recent softening of U.S. data has pushed U.S. 10-year yields down by 30 basis points more than those on German bunds, causing the euro to rise to US$1.10 as of November 30 from US$1.045 in early October.

The decline of European inflation also offers a helping hand to consumers amid wage gains that are typically stickier in Europe than in other regions. Economists expect inflation to fall even as wages continue to rise, translating into greater purchasing power and a higher standard of living for Europeans.

One final leg holding up the euro is the expected repatriation of the 4 trillion euros invested abroad between 2014 and 2022, when the ECB imposed negative interest rates on European savers. Only a fraction of that money has returned to Europe, but with short-term interest rates 4.5 percentage points higher than they were 18 months ago, we expect to see gradual and persistent demand for the euro as this money finds its way home. This allocation shift will accelerate as Europe’s economic prospects improve relative to the U.S..

Our euro forecast of US$1.21 implies that the euro will rise 10% in 2024. This may seem aggressive compared with the narrow trading range over the past year but is small in the context of regular currency-market fluctuations and relative to the euro’s average 18% annual range from the past four decades (Exhibit 11). The tailwind of a broad U.S.-dollar decline will contribute to the euro rally, and so the euro should end the year stronger even in the absence of a rosy European economic outlook.

Exhibit 9: European inflation falling faster than in other regions

Note: As at November 30, 2023. Source: U.S. Bureau of Labour Statistics, U.K. Office of National Statistics, Eurostats, Statistics Canada, RBC GAM

Exhibit 10: Improving European data surprises

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

Exhibit 11: Euro trading in tight range relative to history

Note: As at November 29, 2023. Source: Bloomberg, RBC GAM

Japanese yen

The yen has traded as we would expect given movements in bond yields (Exhibit 12), weakening as the Fed has hiked rates and as the Bank of Japan (BOJ) remains stubbornly on hold. The move has been contained by the threat of intervention by the Ministry of Finance, which has warned that it could purchase yen to fend off excessive declines. Realistically, intervention will do little to slow the massive capital movements aiming to capture the historically wide yield differences between Japan and the rest of the world. Global bond investors have shunned Japan for better returns elsewhere and investors are still shifting funds from Japan at the fastest pace in decades and at a rate that outpaces even the country’s solid income receipts from assets held abroad.

A change in sentiment toward the yen will only materialize when Japan’s interest-rate disadvantage narrows, and there’s scope for this to happen in two ways. The first would be via interest-rate cuts by other developed-market central banks and the second through a tightening in policy by the BOJ. We think both of these outcomes are plausible over the next 12 months, particularly the latter, as wages rise at a solid clip in Japan and as core inflation climbs to highest levels since the early 1980s (Exhibit 13). Our forecast of 130 yen per dollar, versus about 147 now, implies that the yen will be among the best-performing currencies in 2024. The forecast relies heavily on U.S.-dollar weakness and an interest-rate pivot by the Japanese central bank.

Exhibit 12: USD-JPY closely tracks U.S. yields

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

Exhibit 13: Japanese core inflation at multi-decade highs

Note: As at November 30, 2023. Source: Japan Ministry of Affairs and Communications, RBC GAM

Canadian dollar

Our long-term view on the Canadian dollar is similar to our outlook for emerging markets: The loonie may face challenges in the short term, but the long-term outook is positive.

The longer-term outlook is predicated on our expectation of sustained U.S.-dollar weakness and strong social and economic factors that will promote demand for the Canadian currency. Examples of these factors include the country’s inclusive society, strong banking system and wealth of natural resources, all of which establish Canada as an attractive destination for immigrants and long-term investors. We may also consider Canada’s fiscally prudent stance relative to other major developed economies (Exhibit 14). Accelerated immigration, while a topic of mounting criticism for its perceived impact on house and rental prices (Exhibit 15), will boost the country’s productive capacity in coming decades.

The reasons we are more skeptical in the short term are twofold. First, a cyclical slowdown in the U.S. will weigh on the Canadian economy, which sends 70% of its exports to the U.S. The possibility that oil prices will decrease due to lower global demand for energy would also weigh on sentiment for a currency that is linked to oil prices, albeit less than has previously been the case.

Second, Canadian households are financially stretched, and the impact of higher interest rates will continue to be felt well beyond the last Bank of Canada rate hike. We don’t expect an imminent collapse in real-estate prices as immigration remains supportive for housing. Instead, we think that higher debt-servicing costs will erode disposable income and thus reduce demand for other goods and services.

These factors do not stop us from anticipating that the Canadian dollar will strengthen over the next year. Our 12-month forecast of $1.27 per U.S. dollar attempts to look beyond the next few months as the U.S. dollar is expected to decline across the board over the next year. We do, however, see the loonie underperforming other major currencies such as the euro and Japanese yen in 2024, while it should fare better than the British pound.

Exhibit 14: Canada in stronger fiscal position than peers

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

Exhibit 15: Immigration driving rental prices higher

Note: As at October 31, 2023. Source: Statistics Canada, Toronto Real Estate Board, RBC GAM

British pound

The pound has delivered a 10% total return versus the dollar so far in 2023 and has been the top-performing developed-market currency over that period. The magnitude of sterling’s gains has surprised us given that, aside from the U.S. dollar, the pound has been our least favourite G10 currency. The bounce from large declines in 2022 represents a reversal of investor pessimism and so is unlikely to be repeated.

We expect the currency to lag those of other developed markets as the country contends with rising unemployment, sticky inflation and lower real interest rates than its peers (Exhibit 16). The pound also stands out in that it is among the minority of currencies that are not substantially undervalued against the U.S. dollar (Exhibit 17). At US$1.27, the currency is only slightly cheap according to valuation models and will likely become overvalued as its fair value drops in reaction to a high inflation-linked diminishment in purchasing power. We forecast that the pound will rise to US$1.31 sometime over the next 12 months, benefiting only modestly from generalized U.S.-dollar weakness.

Exhibit 16: Real 5-year UK vs. developed market yields

Note: DM yield is the average 5y real yields for USD, EUR, JPY, SEK, AUD, CAD. As at November 30, 2023. Source: Macrobond, RBC GAM

Exhibit 17: GBP-USD – Purchasing Power Parity Valuation

Note: As at November 30, 2023. PPP = Purchasing Power Parity. Source: Bloomberg, RBC GAM