After a number of years of US dollar appreciation, expectations for 2017 were also elevated, with investors positioned accordingly. President Trump would throw fuel on a US economy already 'on fire', in turn triggering more rate hikes by the Federal Reserve (Fed). At the same time, investors judged that the euro was undervalued, but for good reason: 2017 would be the year of many contested elections, with a risk of a move to the populist right. In addition, economic tail risks hadn't been extinguished, with some of the smaller euro members still struggling with their budgets.
However, 2017 actually saw broad-based US dollar weakness. And the start of 2018 hasn't been any different. The chart below shows that only a few currencies have weakened against the greenback, while the US dollar is down more than 10% against a basket of its major peers since early 2017.
So, what went wrong for the US dollar? Or more to the point, what went right for the euro?
One of the important drivers of currencies are interest rates. At the start of 2017, US interest rates were expected to rise on the back of rate hikes by the Fed. The Fed duly delivered three rate hikes, but investors have been unwilling to factor in many future hikes. With US inflation underwhelming expectations for most of the year, market pricing has stayed below the Fed's 'dot plot', which shows the overall rate projection from policy makers. Rate differentials between the US and the Eurozone may have increased amid the monetary tightening, but forward-looking rate differentials haven't.
The next chart shows the actual three-month interest rate differential, as derived from the currency forward curve. This is effectively the interest cost you pay for hedging US dollars back to euros, but with an additional forward-looking component to capture investor expectations of hedging costs in two years' time. As shown, the forward-looking interest rate differential hasn't increased at all since early 2017, meaning that the expected divergence in interest rates has not happened (the European Central Bank's policy settings remain extremely accommodative).
On the fundamental side, the Eurozone saw something of a 'resurrection' in 2017. First, it shielded off a number of political threats. Second, relative to expectations at the start of the year, economic growth, unemployment and inflation were all better in European monetary Union than in the United States. As a consequence, default risks in Greece or Portugal, for example, have collapsed.
These developments have allowed for a normalisation in the euro-US dollar exchange rate, with the euro's relative cheapness having disappeared completely according to our valuation metrics, as shown in the next chart.
So with Europe having ridden the wave of economic and political prosperity in 2017, and the euro having appreciated close to fair value against the US dollar, what's next?
We believe that it will be harder for the European economy to outperform this year given today's more elevated expectations. Tail risks in Europe can hardly be priced out further, as most concerns have evaporated. Even the coming elections in Italy are receiving little attention from markets.
That just leaves us with interest rate differentials, which we believe will move more convincingly in favour of the US dollar over the next couple of years. As such, we remain broadly long the US dollar in our portfolios, including against the euro. This makes even more sense to us in a portfolio context, as a rise in US inflation is on top of our list of potential threats that could unsettle multi-asset portfolios.