The U.S. dollar is unlikely to continue defying gravity

If our outlook is correct, foreign exchange should add 1.1 percentage points annualized to the returns that U.S. investors derive from dividends, corporate profits, and valuation changes of international equity investments. Such a boost assumes a broadly diversified portfolio that is invested initially in U.S. dollars and not hedged against currency risk.

Our expectation of an easing in the dollar’s value is one reason we believe dollar-based investors will earn higher returns on non-U.S. equities than U.S. equities in the decade ending September 30, 2033.** For detailed projections by asset class, see our Vanguard Capital Markets Model® forecasts.

“The exceptional run-up in the value of the U.S. dollar was partially justified by attractive valuations 10 years ago and stronger fundamental U.S. economic conditions over the last decade,” said Ian Kresnak, an analyst in our Investment Strategy Group and the lead creator of our exchange rate model. “However, we think the dollar has gone too far and that a correction to our fair-value estimate will drive dollar depreciation in the decade ahead.”

“Currencies can deviate from their fair values for brief or even extended periods due to factors both rational and irrational,” Kresnak said. “In the long run, however, fundamental economic conditions do a good job of explaining currency values. We expect that will continue to be true, which implies some depreciation and a return to fair value for the dollar based on our outlook for those fundamentals over our 10-year forecast horizon.”

Kresnak and Lukas Brandl-Cheng, an analyst in our Investment Strategy Group and co-creator of our exchange rate model, identified four cross-border variables that drive the value of the dollar. (See adjacent bar chart.) The first two are particularly important over longer periods:

1. Productivity differences. A larger increase in the value of goods and services produced per capita in the United States compared with many competing countries was a key driver of the dollar’s appreciation in the last decade. We expect the U.S. to maintain its productivity edge, given higher public and private investment and technological innovation, but see a less compelling case that relative U.S. productivity gains will match those of the last decade, easing pressure for the dollar to rise further.***

2. Long-term real (inflation-adjusted) interest rate differences. Higher 10-year rates imply higher expected returns and attract capital from yield-seeking investors. In the last decade, real rates tended to move higher in the U.S. relative to other regions, adding to the dollar’s strength. We expect that trend to persist, albeit at a slower pace.

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.”