3. Policy rates differences. Changes in short-term (2-year) bond yields reflect expectations for central banks’ policy rates. We expect differences in cross-border short-term rates to continue to make a negligible positive contribution to the dollar as global inflation and policy rate differences converge in line with our economic outlook.
4. Inflation rate differences. Conventional wisdom suggests that higher inflation in one country should weaken its currency. When central banks have credible inflation-targeting frameworks, however, research finds that—all other factors being equal—upturns in inflation strengthen their currencies. That’s because accelerating price gains for goods and services also lead to higher expected interest rates. Cross-border inflation differentials boosted the dollar modestly in the last 10 years but likely will be a small force for depreciation going forward.
Even if the United States confounds our expectations by delivering meaningfully better productivity or higher long-term real rates than other countries in the coming decade, we think these factors will only modestly offset, rather than cancel out, the looming depreciation of the dollar. That said, overvaluation is not necessarily an indication that a dollar sell-off is imminent, especially if the global economy is headed for recession.
“We have high conviction that the U.S. dollar will correct over the long term to levels implied by fundamental economic forces,” said Kresnak. “But identifying the catalyst for a weakening dollar is difficult, and its volatility could lead to an abrupt correction or further deviations from fair value. For those reasons, we’d caution investors against trying to time to currency markets and instead encourage them to view our forecast as a modest long-term tailwind for globally diversified portfolios.”