Is the U.S. dollar bull market coming to an end?


Is the end of the dollar’s multiyear rally on the horizon? We examine the drivers of the rally, what’s changed, and the implications for global investors.


February 8, 2023

By Alan Robinson

  • The value of the dollar moves in long-term bull and bear cycles, each of which lasts roughly a decade. We may be transitioning from a bull to bear cycle at this time.
  • Certain investment styles that worked well during the previous cycle may start to surrender leadership and prompt a re-evaluation of global portfolios.
  • We examine industry sectors, asset classes, and geographies that should benefit from a falling dollar and note that dollar-denominated investors may benefit from more international exposure.

The first decade of this century was a tough one for the greenback. Global investors questioned the status of the dollar as a reserve currency, and the euro appeared to be in its ascendancy. But by 2011, the depressed sentiment and cheap valuation of the dollar on a purchasing power parity (PPP) basis set the stage for the start of a bull cycle for the dollar that impacted most global investment classes.

Fast forward to the end of 2022, and a combination of rapidly increasing U.S. interest rates and a flight to the relative “safety” and liquidity of the U.S. dollar in the face of rising geopolitical tensions had pushed the dollar to more than 25 percent above its fair value level as measured by PPP. Its rapid ascent and subsequent decline since its high in September 2022 suggests to us a new multiyear down cycle may have started for the dollar. This has implications for asset allocation decisions for long-term investors.

The dollar moves in recurring long-term cycles

Trade-weighted U.S. Dollar Index (DXY)

Trade-weighted U.S. Dollar Index (DXY)

The line chart shows the value of the trade-weighted U.S. Dollar Index (DXY) at the end of each month from January 31, 1985 through December 30, 2022. Four distinct phases of upward and downward movement are highlighted: from 1985 to 1995, the index fell by 51%; from 1995 to 2002, the index rose by 51%; from 2002 to 2011, the index fell by 40%; from 2011 to September 2022, the index rose by 58%. The index has moved down in each of the three months since October 2022.

Source – RBC Wealth Management, FactSet; monthly data from January 1985 to December 2022

A primer on the currency markets

Why do we think the dollar may have peaked? To answer that, it’s worth looking at the factors that influence currency valuations. An important point is that currencies don’t trade in isolation. Currency prices are all quoted relative to another currency. If one currency goes down, a different currency will appreciate. So the drivers of a nation’s currency depend on the strength of its economy and finances relative to its trading partners.

Three factors broadly drive currency valuations: interest rates; budget deficits or surpluses; and terms of trade, or the global market price of a country’s exports relative to its imports. Budget deficits can act as a currency headwind. Some emerging economies that run up large spending deficits tend to see their currencies fall, particularly if they print money to address the shortfall.

But the biggest driver of recent global currency moves has been interest rate differentials between countries. The COVID-19 pandemic triggered the sharpest rise in inflation in a generation. The Federal Reserve’s steep interest rate hikes to combat this inflation outpaced those of other countries’ central banks. Foreign investors were able to convert their currencies into dollars and park the funds in short-term accounts with a much higher interest rate than they could achieve at home. And thus, the final leg of the dollar’s rally was born.

As good as it gets?

Many of these longer-term drivers of dollar strength appear to be reversing. Global central banks are catching up with the Fed’s rate hike regime just as traders anticipate an end to this cycle and the potential for U.S. rate cuts a few quarters out. We believe this will act to erase the interest rate differential that has driven the dollar higher.

Meanwhile, the recent standoff over increasing the U.S. debt ceiling has shone a spotlight on the country’s budget deficits. Even the country’s changing terms of trade provide a headwind as U.S. consumers pivot from spending on cheaper imported goods in favour of more expensive services.

We are not suggesting that the start of a dollar bear cycle means its role as a reserve currency is under threat (see our April 2022 commentary from the Global Insight Weekly). But we do expect increasing diversification of investment assets out of the dollar as the cycle progresses.

What are the investment implications?

History provides a few pointers to investment themes that might work in a dollar bear market, some more reliable than others.

Stock valuations

Over the course of the last few long-term dollar cycles, there has been a close relationship between equity valuations and the strength of the dollar. When the dollar strengthens, price-to-earnings multiples for stocks rise too, with multiples falling again as the dollar weakens. This holds for international as well as U.S. equity valuations. While global stocks can still perform well during dollar bear cycles, we note that earnings growth will likely be more important than valuation expansion in this environment. This may favour dividend-paying stocks with more reliable cash flow characteristics.

Equity valuations rise and fall with the dollar

Trailing price-to-earnings multiples versus the trade-weighted Dollar Index (DXY)

Trailing price-to-earnings multiples versus the trade-weighted Dollar Index (DXY)

The line chart compares the value of the trade-weighted U.S. Dollar Index (DXY) and the trailing price-to-earnings multiple of the S&P 500 Index weekly from January 22, 1993 through January 20, 2023. The two data series tend to rise and fall together.

  • U.S. Dollar Index (LHS)
  • S&P 500 trailing P/E (RHS)

Source – RBC Wealth Management, FactSet; weekly data, 1/22/93–1/20/23

International stocks

Equity markets outside of the U.S. tend to do well when the dollar is weak. International stocks outperformed their U.S. peers in 2022, driven by cheaper valuations, but the pause in the dollar bull cycle over the last three months of the year probably played its part too. In a weakening dollar environment, domestic U.S. investors can typically capture the outperformance of overseas markets plus the benefit of stronger overseas currencies when translated into dollars.

Some international equity markets perform better than others in a weak dollar environment. Emerging markets tend to outperform, although we think it would be wise to be selective as globalisation fades. Commodity exporters should outperform, while countries that predominantly export to the U.S. may struggle.

It’s good to diversify stock portfolios during dollar bear markets

Annualised stock market returns in local currency and U.S. dollar terms, January 2002–May 2011

Annualised stock market returns in local currency and U.S. dollar terms

The bar chart compares the annualised stock market returns in local currency terms to the returns in U.S. dollar (USD) terms during the last dollar bear market, from January 2002 to May 2011, for six major developed-market stock indexes. U.S. (S&P 500): 1.9% domestic currency, 1.9% USD. UK (FTSE 100): 1.6% domestic, 3.3% USD. Japan (TSE TOPIX): -1.6% domestic, 3.8% USD. Europe (STOXX 600): -0.4% domestic, 5.2% USD. Australia (ASX All Ordinaries): 3.7% domestic, 12.4% USD. Canada (S&P/TSX Composite): 6.5% domestic, 12.4% USD.

  • Returns in domestic currency
  • Returns in U.S. dollar terms

Source – RBC Wealth Management, FactSet

U.S. equity sectors

The picture is a little less clear for U.S. stocks in a dollar bear market. Large caps and, in particular, multinational companies tend to perform relatively well as they have a higher proportion of profits generated from outside the U.S., most of which are denominated in appreciating foreign currencies.

We analyzed the returns of each U.S. sector from the start of the most recent dollar bear and bull cycles, and the results are mixed. We believe this is because the longer-term investment cycles of equities, coupled with rapid technological and business changes this century, tend to outweigh the effect of the dollar cycle.

However, we note that Energy and Materials companies tend to outperform when the dollar falls, as commodities that are priced in dollars typically are in more demand during a dollar bear cycle. On the surface, it would seem that the currency used for a transaction should have little bearing on aggregate demand for that product, but in the real world oil and hard industrial commodities enjoy a demand tailwind when the dollar is weak as those commodities become cheaper to buyers outside of the U.S.

Beyond those sectors it’s a mixed bag, although Technology and Industrials companies, with their relatively high overseas revenue streams, should be insulated from a falling dollar. Domestically focused sectors such as Real Estate, Utilities, and Banks have less exposure to foreign currencies and their performance may lag in a dollar bear cycle.

Fixed income markets

Bonds denominated in international currencies should enjoy more demand in a falling dollar environment, all else equal. And if a falling dollar reduces imported inflation in these countries, interest rates may decline, further helping their bonds. Emerging market issues, which are often denominated in dollars, should also do well as their yield spreads relative to risk-free rates start to narrow. Many emerging market issuers struggle to fund their dollar interest payments when their domestic currencies are weak, but a falling dollar should make those payments easier.

Closing chapters?

We can’t say that the dollar bull cycle is over yet, and the rally that started in 2011 could possibly still have several quarters to run. The speed of the dollar’s decline since its 2022 peak suggests we may see a bounce higher before a down cycle is established in earnest. We won’t know for sure until after the fact, but if history is a guide we’re probably much closer to the end of the dollar bull cycle than the beginning. We think it’s worth considering now how to position portfolios in anticipation of a sea change in the dollar.

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