The US dollar is extremely overvalued and if history is any guide it is poised for a substantial multi-year fall.
The value of the US dollar, shown by its real exchange rate in the chart below, has been remarkably cyclical over the past fifty years. Since the end of the Second World War, there have been three previous instances of extreme dollar overvaluation: the 1970s, the mid 1980s and the early 2000s. In the 1970s, the overvaluation was caused by high inflation within a fixed exchange rate regime (“Bretton Woods”); in the mid-1980s, the overvaluation was caused by Fed policy under chairman Paul Volcker that saw rates rise to double digits to squeeze inflation out of the system (“Volcker Shock”); and in the early 2000s the overvaluation was driven by the tech boom drawing in capital to the US (“Productivity Miracle”).
One thing that all three of these prior episodes of dollar overvaluation have in common is that they did not last. In each case, the US dollar, as measured by its trade-weighted exchange rate against a basket of its peers, saw a massive depreciation over a multi-year period. These historical precedents suggest that the US dollar is poised for a substantial, multi-year fall. We believe the current strength of the US dollar makes a clear case for US dollar unhedged global fixed income mandates, especially when considered against the backdrop of rising yields, divergence in value between US and international credit markets, and the build-up of recessionary risks.
The value of fixed income instruments is affected by interest rates, inflation, and credit ratings. Although, investments in emerging markets offer a higher yield, they involve a greater risk of loss and higher volatility than investments in developed markets. Higher yielding bonds tend to carry a greater risk of loss due to issuer default.
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