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The U.S. Dollar At A Crossroads: Estimating Fair Value

Authors: Roger A. Aliaga-Díaz, Ph.D.; Qian Wang, Ph.D.; Giulio Renzi-Ricci, M.Sc.; Asawari Sathe, M.Sc.; Jonathan Petersen, M.Sc

In the 12 months following July 2014, the U.S. dollar (USD) soared 20% amid falling oil prices and further monetary easing in Japan and Europe. As USD appreciation tightened global financial conditions, world industrial production growth declined over those 12 months by more than half, from 3.5% to 1.5%. This same dynamic is apparent with the latest cycle of reflation and slowdown (Figure 1). As the Federal Reserve has reduced interest rates while trade tensions are escalating and global growth signals are flashing amber, debate is intensifying about the USD’s likely direction and its implications for the global economy and portfolios. Our analysis shows that the U.S. dollar is close to fair value based on economic fundamentals, poised to fluctuate around current levels absent a change in those fundamentals or an economic shock. A balanced, long-term approach will help investors weather the consequences of a stronger or weaker USD.

In this paper, we first provide a conceptual overview of currency valuation and the key drivers of currency prices. We then apply these concepts to calculate what economic fundamentals imply for current levels of Group of Ten (G10) currencies.1 Finally, given the USD’s unique contribution to global financial conditions, we analyze what USD fluctuations imply for asset-class returns.

Vanguard’s approach to estimating fair value

Freely floating currencies are one of the primary means of adjustment that enable balanced trade in goods, services, and capital across borders. One building block for currency valuation and estimated fair value is the “law of one price,” also known as purchasing power parity (PPP): The same product sold in two different countries should cost the same when expressed in a common currency. A smartphone in Japan, for example, should cost the same as one in the United States in USD terms; otherwise, an arbitrage opportunity might exist where someone could buy a good at a lower price in foreign markets.2 Despite evidence that the law of one price holds over long periods, currencies can deviate from this theoretical equilibrium for years at a time. In addition, PPP does not reflect transaction costs or non-tradable goods and services (such as haircuts). A broader measure of relative prices, such as consumer price indexes, is a better means for computing the real exchange rate (RER).3

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1 G10 currencies are the USD, Japanese yen, British pound, euro, Swedish krona, Norwegian krone, Swiss franc, Canadian dollar, Australian dollar, and New Zealand dollar.

2 The Economist’s “Big Mac Index” is one popular example of PPP being measured using identical goods in different markets.

3 Deviations from a real exchange rate consistent with the law of one price can be adjusted through two different channels: either changes in the ratio of consumer prices in the two countries (that is, changes in relative inflation rates), or changes in the two currencies’ nominal exchange rate. A recent working paper by the European Central Bank found that nearly all the adjustment occurs through nominal exchange rates rather than relative consumer prices (Ca’ Zorzi and Rubaszek, 2018). For example, after the USD’s 2014 rally, relative consumer prices in Europe and the U.S. remained relatively constant, while the nominal exchange rate eventually reverted in favor of the euro.

4 More precisely, REER measures the value of a currency against a weighted average index of foreign currencies adjusted for inflation differentials. Note that effective denotes a currency index rather than a bilateral rate. As our analysis focuses on bilateral rates, we simply use real exchange rates rather than currency indexes.

5 One drawback is that this approach calculates equilibriums based on bilateral exchange rates, when it is conceptually more accurate to calculate an economy’s equilibrium based on the exchange rate against a broad set of currencies. To mitigate this drawback, we calculate one cross-country equation using a panel data set, 2 which improves the robustness of our estimates. See the Appendix for further technical details about our BEER model.

Originally Posted on August 29, 2019 – The U.S. Dollar At A Crossroads: Estimating Fair Value

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