The resurgence of the U.S. dollar has been one of the leading investment stories of the last few quarters. A somewhat modest recovery in the United States has galvanised investors, who appear to believe once again in the currency version of the American dream. In contrast, headlines about the Eurozone malaise, the failed jump-start of the Japanese economy, and slowing growth in the emerging markets vindicate further depreciation in their respective currencies. No wonder strategists are forecasting further appreciation of the dollar (Ramage, 2015).
The comeback of the dollar appears very reasonable if based on a narrative about macroeconomic fundamentals. However, this narrative only partially reveals what has been taking place in the currency markets. It is insufficient for forming an educated guess about future scenarios and understanding the risk/return trade-offs that investors might be facing.
In this piece, I look at the performance of the U.S. dollar from a different angle. My goal is to explain the rally by looking at well-known currency factors and by illustrating their relationship with macroeconomic cycles. The classic paper by Meese and Rogoff (1983) showed that macroeconomic fundamentals are poor predictors of exchange rate movements at short horizons. In the spirit of the arbitrage pricing theory pioneered by Ross (1976), the cross-section of currency returns appears to be better characterised by a few risk factors.
But which factors? There are at least three of them to keep in mind: the carry trade, momentum, and value. I contend that, in the prevailing market environment, the carry trade and momentum strategies sit uneasily with increasingly high valuations.
The "Old-Fashioned" Carry Trade
To explain what happens in currency markets, the usual suspect is the carry trade. This popular strategy consists of buying currencies of countries that offer relatively high cash rates and selling those of countries that offer relatively low cash rates. Depending on the measurement period and the sample of currencies considered, the carry trade has delivered annual returns above 4% and a Sharpe ratio higher than that of the U.S. equity market.1
However, as shown by Lustig et al. (2011), these returns do not appear to be a free lunch. Instead, they are likely explained by their correlation with global financial risk.2 The carry strategy is profitable in the long run, but it might result in painful losses precisely when investors might least want them.
This time, however, the carry trade as traditionally executed does not appear to be the main culprit. As Figure 1 displays, what we have observed in the last few months is the U.S. dollar's broad appreciation against both developed and emerging market currencies. Lustig et al. (2014) show that this generalized trend is typically related to the "dollar carry trade."