Why A Stronger US Dollar Is Justified

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By Chris Shaw

Having recently traded as high as 1.35 against the US dollar the euro in the opening sessions of this year has fallen below 1.30, coming close to the upper level of its previous trading range.

While market commentator Dennis Gartman suggests the correction is simply a re-test of its breakout and so is a normal reaction to a strong move, GaveKal Research takes an opposite position in suggesting the move supports its view the US dollar is very undervalued against the euro in particular, so the turnaround is likely a precursor of further strength.

The analysts offer four reasons why the dollar should be stronger, the first being growth differentials between the US and Euro-zone economies. GaveKal argues currency valuations over time tend to move in line with the return on invested capital, a trend that supports a stronger greenback given the US economy has outperformed the EU in every quarter since the first quarter of 2002.

Also in favour of the US dollar is the difference in interest rates around the world, as in GaveKal’s view the Federal Reserve is likely to hold interest rates steady for longer than most in the market view as likely. At the same time, the analysts suggest lacklustre demand in both the European and Japanese economies will limit the extent by which rates can be increased in both those regions, so maintaining the differential in rates in favour of the US.

Valuations also favour the greenback in the group’s view, as in purchasing power parity terms it sees the US dollar as undervalued against the euro. Also helping the dollar is the recent fall in oil prices, as this reverses the trend when oil prices are high of petro dollars being recycled everywhere but in the US.

At the same time, lower oil prices help shrink the US trade deficit given America is a major importer of oil, an outcome the group also sees as a positive for sentiment regarding the currency.

GaveKal suggests all the indicators from fundamentals to technicals to valuation now favour a stronger US dollar, an outcome it sees as very different to what a number of forecasters had anticipated would be the case this year.

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