Market Perspectives

U.S. dollar faces another challenging year

01.22.2018

The U.S. dollar had a rough year in 2017, with the benchmark U.S. dollar Index (DXY) falling 11% for the year and the dollar declining in value against every currency from the “Group of Ten” industrialized countries.
What’s the potential for 2018?

Dollar stumbles in 2017

The dollar began 2017 priced for perfection, having rallied 6% between election day in November 2016 and the end of that year. The U.S. Federal Reserve made three interest rate hikes during 2017, as promised, but the administration of President Donald Trump and the Republican-controlled Congress had little success in delivering on campaign promises.

Repeated attempts to “repeal and replace” the Affordable Care Act ended in failure and there was no infrastructure bill. To make matters worse for the dollar, the Consumer Price Index actually fell over the course of the year, snuffing out hopes for more rate hikes that might have acted to support the dollar. Tax reform legislation finally was passed and signed into law in December, and we think that legislation will play a role in supporting the dollar in the first half of 2018.

Key currencies rallied against the U.S. Dollar during 2017

Source: Bloomberg; percentage change in value of selected currencies vs. U.S. dollar for the period 01/03/2017-12/29/2017

A tale of two halves in 2018

We now expect the dollar to rally in the first half of the year and then reverse that move in the second half – if not slightly sooner. By the end of 2018, we think the dollar’s value will be lower than where it started the year versus most of the major currencies. However, we think the depreciation in the dollar will not be nearly as great as it was in 2017.

We think the dollar will get a boost in the first half of the year from the recently enacted tax cuts as well as an expected Fed rate increase in late March. This forecast assumes U.S. inflation does not increase significantly and the market accepts and uses the Fed’s guidance of 75 basis points in rate increases for the year.

As we approach mid-year, we think the Fed will make another rate hike in June, but by then the market is likely to begin looking at the impact of the European Central Bank ending its asset purchase program.

It also is possible that the Bank of Japan will recalibrate its yield curve control program during the course of the year, possibly by moving the target from the 10-year bond to the 5-year and allow its yield curve to steepen. That action in turn would tend to support the yen.

The pound stands out as a possible exception, as we think it could rally throughout 2018. The pound was oversold after the U.K.’s decision to leave the European Union, or “Brexit,” but has held up well through elections there and continued Brexit negotiations. Barring a major derailment in those negotiations, we think the pound could rally to $1.40-$1.45 by year end.

We also think the Canadian dollar could rally throughout the year. A run of strong employment growth late in 2017 helped push the Bank of Canada (BOC) to hike interest rates in mid-January. This increase came two to three months earlier than the market had expected in early December. While risks from the ongoing negotiations on the North American Free Trade Agreement, or NAFTA, could weigh on the Canadian dollar, we think a strong U.S. economy combined with higher oil prices and two to three more hikes from the BOC this year are likely to support continued Canadian dollar appreciation.

Summary outlook for key exchange rates

There are some short-term headline risks that could impact the U.S. dollar, including geopolitical issues and the ongoing distractions in Washington that have prevented the federal government from making headway on key priorities. In addition, we can expect a debt-ceiling fight in March and ongoing headlines from the Trump administration. In summary, we forecast exchange rates between the dollar and key currencies in 2018 as follows:

U.S. Dollar forecast to rally early in the year, but decline in value by end of 2018
Currencies 1st Half 2018 2nd Half 2018 Comments
U.S. dollar to euro 1.12-1.14 1.22-1.25 Dollar likely to rally in first half, then decline
Yen to U.S. dollar 118.00 110.00 Dollar back to 2016 highs, then lower to end year
U.S. dollar to U.K. pound 1.40 1.45 Steady gain likely in pound during year

Source: Ivy Investments forecasts of exchange rates in 2018 for currencies shown.

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Key Takeaways

  • We expect the dollar to rally in the first half of the year, then reverse that move in the second half.
  • We think the dollar will get a boost from recent tax cuts as well as expected Fed rate increases.
  • The depreciation in the dollar for 2018 is not likely to be as great as it was in 2017.

Investment team

Michael Yeager

Vice President Foreign Currency & International Economics