Where The U.S. Dollar Is Headed

Key points

• We see a modestly higher U.S. dollar ahead. This supports the case for non-U.S. stocks, and we see resilience in emerging market (EM) equities.
• The Bank of England (BoE) increased rates for the first time in 10 years, and European stocks hit a ten-year high on upbeat eurozone growth data.
• U.S. President Trump plans to visit China this week, as part of a multi-country trip in Asia. We expect trade and North Korea will be in focus.

We see a mildly stronger U.S. dollar (USD) ahead. But we believe many of the asset classes that generally suffer when the USD appreciates - including commodities and most EM assets - will be more resilient this time around.

U.S. two-year yield premium and U.S. dollar, 2016-2017

Sources: BlackRock Investment Institute, with data from Thomson Reuters, IMF, Bloomberg, November 2017. 
Notes: The U.S. dollar is based on the U.S. Dollar Index (DXY). The U.S. yield premium is calculated as the U.S. two-year government bond yield minus a composite of two-year eurozone, Japanese and UK yields that are gross domestic product-weighted. The premium is shown in percentage points. The eurozone yield is based on an average of German, French and Italian two-year government bond yields.

A key U.S. dollar index has depreciated roughly 7% this year. Some are betting on further declines; speculative short positioning is at three-and-a-half year highs in the futures market. We believe this positioning buildup led to an April break in the usual positive correlation between the USD and the U.S. yield premium over other developed markets. Yet we see the USD's broad uptrend since mid-2014 slowly resuming as monetary policy divergence re-emerges. The Fed is normalizing rates while the European Central Bank and Bank of Japan maintain easier policies, and the positive correlation between the USD and yield premium has returned.

Weathering a stronger dollar

We see a stronger U.S. dollar as the Fed normalizes ahead of its developed market peers and U.S. economic growth shows upside potential. However, we expect the gains to be moderate over the short term, as Fed rate rises will likely be slower than in past cycles given relatively tame U.S. inflation. Our BlackRock Inflation GPS points to U.S. core inflation returning to 2% in six months' time.

Commodities and EM assets have had an inverse correlation to the USD in many historical periods, falling when the USD is stronger and vice versa. But we don't believe a mildly stronger dollar necessarily spells bad news this time around. This is because we see other factors driving these assets' performance. Commodities have rallied and EM equities have outperformed their developed market counterparts over the past month despite a stronger USD. Local EM debt was an exception, with returns dragged down by local currency weakness. Supply-demand fundamentals can also trump the usual negative relationship between commodity prices and the dollar.

Oil prices, for instance, neared a 27-month high last week on improving demand and expected supply cuts. Similarly, we see EM equities able to withstand a modestly higher USD amid improving economic conditions, earnings growth and investor sentiment. We see a stronger USD versus the euro and yen supporting equities in the eurozone and Japan, given these stock markets' export-oriented nature. The major risk to our view is a sharper dollar appreciation. U.S. tax reform is a wildcard here: Deficit-financed tax cuts could boost U.S. Treasury issuance and growth, leading to higher interest rates and a more rapid dollar rise.

Bottom line: We believe a modestly higher USD ahead supports the case for favoring eurozone and Japanese equities, and it does not change our preference for EM stocks. Within currencies, we favor the USD to the euro and yen amid monetary policy divergence.