Is the dollar overvalued? That depends how you view it

EghtesadOnline: As doubts grow over whether the dollar will resume the rally that took it to 14-year highs against other major currencies early this year, at least one measure seems to show the greenback may have indeed peaked.

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24 March 2017

The Federal Reserve Economic Data (FRED) index which measures the dollar on a trade-weighted basis against 26 peers, shows the currency's end-2016 strength took it close to highs last seen in early 2002, before falling U.S. interest rates and a firming euro pulled it lower, according to Reuters.

Unadjusted for inflation, the FRED broad index shows the dollar hit a peak of 128.79 at the end of December last year - less than 1 percent short of its February 2002 top of 129.87.

However, as this graphic shows reut.rs/2nhaq16 when adjusted for inflation, the same index shows the dollar's average monthly strength which peaked in December is nearly 9 percent below its early millennium high.

The dollar surged to a 14-year high after Donald Trump's election as president last year on expectations of tax changes that would see billions repatriated to the United States and allow the White House to spend more, boosting growth, inflation and interest rates.

That faith has evaporated steadily since the turn of the year and the dollar has fallen against all of its major peers in response, slipping further after the Fed's "dovish hike" this month when it raised interest rates but indicated there would be fewer more hikes this year than some in markets had expected.

"Real exchange rates tend to mean revert, and the U.S. dollar is now clearly overvalued in the sense that it is higher than its expected value on a 2-5 year horizon," said Patrik Säfvenblad, chief investment officer at hedge fund Harmonic Capital Partners in a note to clients.

So which measure to trust?

The orthodoxy has long said that currencies can only be understood in terms of their current purchasing power.

But some currency strategists say that may be less relevant in a world where inflation has been largely absent since the global financial crisis after a quarter-century of central banks targeting inflation.

"Inflation has been dead for eight years pretty much apart from various energy-induced variations," said Neil Mellor, currency strategist at Bank of New York Mellon in London.

"So really, in many respects nominal rates and real rates align themselves anyway and hence it would not be a great consideration."