Is the strong dollar momentum unstoppable? UBS: The U.S. economy drives the dollar's "super cycle"

According to Zhitong Finance, President Trump's "America First" trade policy requires the U.S. Treasury to investigate foreign exchange manipulation. This means that the issue of a strong dollar has been brought back to the agenda, although opinions vary on the source of the strong dollar. UBS released a research report stating that although the dollar remains the primary global reserve currency, UBS does not believe this is the reason for the dollar's continued appreciation in recent years. Instead, UBS believes that the strength of the dollar is largely explained by relative economic performance, often referred to as "American exceptionalism."

Last week's volatility in tech stocks prompted people to consider what drives this exceptionalism and how sustainable it is. This article explores these details and presents the following points:

1. The dollar's super cycle is related to the surge in U.S. productivity relative to other G10 member countries: since 2011, the U.S. per capita GDP level has increased by 11 percentage points compared to the average level of the G10 excluding the U.S. Additionally, the increase in U.S. oil and gas production means that recent energy price shocks have benefited the dollar rather than harmed it.

2. The differences in productivity growth are mainly due to economic slowdowns outside the U.S.

3. The number of U.S. stocks held by foreign investors has surged relative to the amount of U.S. bonds held, which aligns with the view that the dollar's rise is based on economic growth fundamentals rather than demand for reserve currencies.

4. Although the dollar is expensive, simple models, such as purchasing power parity models, overestimate its value precisely because they do not take into account factors such as productivity and trade conditions. The dollar is more likely to weaken through a reduction in American "exceptionalism" and a decrease in foreign investors' accumulation of U.S. assets rather than through interventionist foreign exchange policies.

Strong Dollar Supported by Economic Fundamentals

The Trump administration has generally remained silent on the dollar issue so far, but this may not last long as the America First trade policy document calls for the U.S. Treasury to address foreign exchange manipulation. During President Trump's first term, his dissatisfaction with the strong dollar was an important issue in trying to reduce the U.S. trade deficit. Currently, the broad real effective exchange rate (REER) of the dollar is about 11% higher than in January 2017, while the U.S. current account deficit has widened by about 1.6 percentage points.

One theory suggests that "the dollar has been overvalued, largely because dollar assets play the role of the world's reserve currency." If global demand for U.S. Treasury bonds is inelastic, this prevents downward adjustments of the dollar and reversals of the U.S. long-term current account deficit. In fact, reserve asset-producing countries have always been "punished" by current account deficits, which is another side of reserve capital inflows. The logical conclusion is that in the absence of a self-correcting mechanism for a weak dollar, interventionist policies (multilateral or unilateral) are needed to compensate for the U.S. competitiveness disadvantage It is clear that the US dollar, as the primary global reserve currency, has unique attributes. One example is the "left tail of the dollar smile curve": when global risk sentiment deteriorates, investors flock to safe US Treasury bonds, driving up the value of the dollar. This dynamic is clearly applicable even when the US itself is a source of instability: the most recent instance was during the March 2023 regional banking crisis in the US, when rising stock market volatility raised concerns about a financial crisis and economic recession, leading to a rebound in the real trade-weighted index of the dollar (USD TWI). This indicates that the status of a reserve currency can indeed prevent a downward adjustment of the dollar, even when such an adjustment might be beneficial from an economic perspective.

However, UBS believes that considering the dollar's status as a reserve currency as the main driving force behind the dollar's continued strength in recent years is a stretch. Instead, UBS argues that the current dollar supercycle—a period of strength lasting longer than previous cycles—is largely driven by old-fashioned economic fundamentals, particularly the significant performance of US GDP productivity. Therefore, unless the fundamentals of US economic growth also deteriorate, UBS is skeptical about the necessity of intervention or whether such intervention could effectively weaken the dollar