USD: Undervalued by 5% on a FEER assessment – Deutsche Bank

Alan Ruskin, Macro Strategist at Deutsche Bank, explains that their most recent (April) long-term valuation models had the USD overvalued by 15% on a PPP basis; 9% overvalued using a behavioral exchange rate model (BEER);  but the USD was undervalued by 5% on a fundamental exchange rate (FEER) assessment.

Key Quotes

 “The US energy goods trade balance improvement is nothing short of stunning.    In 2008, the energy trade deficit at -$423bn was larger than the non-energy balance goods deficit of -$408bn.   By 2016, the -$62bn energy deficit was a mere 9%  of the non-energy balance of -$687bn.”

“For the USD valuation, the US energy revolution represents more than a large favorable terms of trade shock, since it impacts both the imported price of energy and trade volumes positively and it improves non-energy competitiveness as well.”

“After 8 years of recovery, the US C/A deficit as a share of GDP, is still smaller than any time in the previous upturn. The US C/A as a % of GDP, has posted a small improvement since 2009 - the first business cycle recovery to show an  improvement since before the fall of Bretton Woods!”

“This largely explains why FEER (external balance) based models suggest modest USD undervaluation, while PPP and BEER suggest substantial USD overvaluation. Given the unusual external balance improvement has a structural component, it is preferable to focus on FEER, rather than BEER models that have underestimated the energy shock.”

“The overall trade improvement does however mask a small trend deterioration in the non-energy C/A balance of approximately 1% of GDP since 2009.  The scale of this non-energy deterioration is not unusual for an upswing. The case for a USD inspired hollowing out of non-energy trade – widely termed ‘Dutch disease ‘ -  is then not compelling.”

“Although ‘Dutch disease’ is not directly being articulated by the Trump Administration as a problem, it is implicit in concerns about the rustbelt’s woes. Given the political climate, some additional monitoring of the US non-energy Current Account is certainly warranted.”

“It is estimated that a 10% USD appreciation adds roughly 1% to the C/A as a percent of GDP over 5 years. Without politics interceding, and assuming monetary policy divergence warrants it, the FEER-based models suggests the USD could appreciate 10% on a real broad TWI (it is already off over 3% from its peak), without flashing serious balance of payments overvaluation concerns.”

“However, in practice this will also be influence by whether the US Administration starts to seize on rustbelt manufacturing problems as being a more serious case of Dutch disease than it currently is.” 

“When it comes to evaluating the USD’s long-term fair value it is preferable to be ‘alert to FEER, and not get led astray by BEER’.”