Question

Paper Rules:

- Choose one Global Finance in Practice as your paper subject from each chapter of the textbook (Fundamentals of Multinational Finance)

For example, you select “JPMorgan Chase Forecast of the Dollar/Euro” from Global Finance in Practice on p.253 of the textbook

- Expand the subject and add other supporting references to your paper

- Apply 1500 words

Answer 1

JPMorgan Chase Forecast of the Dollar/Euro

The U.S. dollar’s exchange rate is critical in shaping financial asset returns for investors around the globe. It has a major impact on U.S. inflation and interest rates, powerfully impacts global commodity prices and is a key determinant of unhedged returns on international investments. So where is the dollar going? We forecast a moderate decline over the next 10 to 15 years. Interest rate differentials – and real economic growth differentials – should narrow between the U.S. and other major economies, resulting in financial flows that should depress the dollar. Another drag on the exchange rate should come from large U.S. trade deficits that will tend to flood global markets with dollars to facilitate U.S. purchases of foreign goods and services. Policy intervention could further pressure the dollar, as the U.S. moves away from its long-held “strong dollar” stance in favor of making exports more competitive. The U.S. dollar (USD) exchange rate is a critical variable shaping long-term asset returns. Presently, the currency is overvalued in real terms, which is likely unsustainable in the long run. We expect the dollar to be pushed gradually lower over our Long-Term Capital Market Assumptions forecast period by:

1. a large U.S. current account deficit .

2. narrowing interest rate and real economic growth differentials between the U.S. and its major trading partners, resulting in relative capital flows supportive of non-dollar currencies.

3. the U.S.’s gradual abandonment of its several-decades old “strong dollar policy”.

It certainly looks to be a win-win for the Dollar over coming years as before any USD-positive recession does materialise, conditions will continue to be Dollar-supportive thanks largely to the U.S.  An environment in which rates are rising by almost 0.25% per quarter is likely to benefit the Dollar. Currencies tend to appreciate because of superior interest rate and growth differentials and these will continue to favour Dollar strength in 2019 as interest rates rise more rapidly in the US than other jurisdictions. Rising interest rates tend to strengthen currencies because they attract greater inflows of foreign capital drawn by the promise of higher returns.

First, balance of payment flows should generally push the dollar down. In the second quarter of 2017, the U.S. current account deficit was 2.6% of GDP, or roughly $500 billion annualized. This is gradually pumping dollars into the world economy and should, by creating an oversupply, push the dollar lower. Inflation differentials should also reduce the nominal value of the dollar. In our Long-Term Capital Market Assumptions, we assume that U.S. inflation will exceed that of most of its major trading partners5 by about 0.7% per year.

Second, financial flows should also generally push the dollar down. As of September 2017, both long-term and short-term interest rates are higher in the U.S. than in most of its major trading partners. To some extent, this simply reflects that the U.S. is further along in its economic expansion than its trading partners, although we expect U.S. rates will continue to be relatively higher in the decade ahead. That said, we are likely beyond the peak of central bank policy divergence and, as such, short-term yield differentials are likely to narrow, providing less support for the dollar compared with the present. Our forecasts show a modest widening of the gap in nominal long-term bond yields, but because of faster rising U.S. inflation, the gap in real long-term bond yields should narrow, putting further downward pressure on the dollar.

Third, policy intervention may push the dollar down in the years ahead. For the last 30 years, under both Republican and Democratic administrations, the U.S. has generally pursued a so-called “strong dollar policy,” despite its negative impact on U.S. manufacturing. However, the presidential election of 2016 may mark a turning point in U.S. trade policy: The Trump administration is more explicitly protectionist than any of its recent predecessors. Moreover, while this protectionism has often been manifested specifically in calls for tariffs or “border adjustments,” a more general stance of encouraging a weaker dollar may yet prove more palatable at home and harder to oppose around the world. While the best example of such a policy is now more than 30 years old, history suggests that a determined and visible attempt by the U.S. to depreciate an overvalued dollar can work. From the dollar’s presently overvalued state, it is reasonable to assume that the currency should follow a path laid out by fundamental forces. Together, these forces—including the U.S.’s significant current account imbalance, a convergence in global interest rates and economic growth rates and the gradual abandonment of the U.S.’s strong dollar policy— underlie our assumption of a gradual decline in the U.S. dollar exchange rate over the next 10 to 15 years.