Currencies do not always behave as they should, and today’s U.S. dollar is a good case in point. By all accounts the U.S. dollar should be on the ascendency, yet it has experienced a steady erosion over the past 12 months and continues to exhibit weakness compared to the other major currencies (Figure 1). The dollar defiesbasic economic principles and conventional wisdom.

Figure 1 US Dollar Index

(Click on image to enlarge)

Textbooks call for currencies to respond to comparative interest rates. However, as Figure 2 demonstrates, the spread between the US. 10yr Treasury yield and those of other major countries is quite wide, especially with respect to Japan (256bps) and Germany (213bps). In theory , these spreads should encourage monies flowing into the United States and , as a consequence, a boost to the U.S. dollar index. More to the point, with the anticipated future rate increases, as the Fed moves to normalize rates, one would expect that the dollar would be the preferred currency among its competitors.

Figure 2 Interest Rate Comparisons

Other factors that a textbook would lay out in favour of a higher U.S. dollar would be the relatively strong economic performance and a more favourable U.S. corporate tax regime. Finally, the heady stock market would provide additional support for the U.S. dollar index to outperform its peer group.

So, what is holding back the dollar from regaining its previous high water mark? One answer offered is that the Chinese and Japanese—who are the biggest holders of U.S.Treasuries—are looking to diversify into other major currencies. However, this argument does not hold up to data scrutiny, as both nations continue to run large current account surpluses with the United States and continue to participate in purchasing Treasuries with their surplus dollars. And, even if diversification were a stated policy of their respective central banks ---which it is not—the process would be relatively slow and would not be apparent in the near term.

Other explanations for dollar weakness reside in the whole matter of U.S. trade protectionist policies. Again, the data so far is not supportive of this claim. Trade flows have not been interrupted as yet, and the outcome for NAFTA is still up in the air. Currency traders need more solid data upon which to place their bets.

Another way to look at this issue is to consider the strength of the Euro and the Yen. The EU and Japan promise stronger growth going into 2018. As yet, there is no evidence that the ECB or the BoJ are tightening monetary conditions that would lead to their currencies strengthening  vis a vis the U.S. dollar. Canada has already raised its policy rate a total of 75bps since the summer of  2017. However it doubtful that the Bank of Canada will continue this upward path given the uncertainties surrounding the NAFTA talks.

One compelling explanation for the weak U.S. dollar is the prospects that U.S. twin deficits  will worsen in the next couple of years. It is estimated that the U.S. tax reform will add $1.5 trillion to the Federaldeficit over the next decade. Despite the protectionist rhetoric, strong U.S. growth will likely add to the current account deficit. These factors may well contribute to a further decoupling of the dollar and interest rates.