The US dollar has appreciated markedly over the past 18 months and is now moderately above fair-value when viewed from a long-term perspective.
If, as seems probable, the Federal Reserve hikes rates in December, the US will be embarking on a journey of significant monetary policy divergence not seen since 1994. This divergence is being driven by solid underlying US economic momentum which has enabled the Federal Reserve to make considerable progress against their statutory objectives of maximum employment and stable prices whilst other central banks, such as the European Central Bank (ECB), still have much work to do. We believe that monetary policy divergence will keep the US dollar well supported in 2016 as rising US interest rate differentials vs. the rest of the world work to attract capital flows into the US.
We also believe there will be a further structural element to portfolio hedging activity which should work in the US dollar’s favour. Long-term strategic hedge ratio studies would suggest that US based investors should typically have hedge ratios on foreign assets above 50% to minimise the risk of portfolio returns when measured in US dollars. This is due to the US dollar’s typical safe-haven properties during periods of risk aversion (i.e. the US dollar tends to appreciate during periods of declining equity prices).
However, whilst hedge ratios for US investors have been trending higher since the financial crisis, they are still low relative to what portfolio optimisation studies would suggest as optimal levels. If US dollar valuations were excessive, then this might act as a significant deterrent to increasing hedge ratios further. However, this is not the case and we believe that the first Fed rate hike in over 10-years, in the same month when the ECB eases policy further and the Bank of Japan continues down its quantitative easing path, should increase the focus of US investors on their unhedged foreign currency exposure and will likely result in a continuation of structural hedging activity that should act as a further tailwind to the US dollar’s performance.