The US dollar is set for a comeback in 2014

USD index chart“It’s easy to forget just how down the dollar is,” says Ian Campbell on Breakingviews. The dollar index, which tracks its performance against a basket of trading partners’ currencies, slid by 40% to a record low between 2001 and 2008. It hasn’t risen much since. But now we can expect a year of “broad US dollar strength”, says Morgan Stanley.

One reason for bullishness is the improving US data. The housing market is recovering and unemployment gradually falling, stimulating consumption, while the fiscal squeeze from Washington will abate this year.

Throw in signs of an uptick in business investment and 2014 “may finally be the year that the recovery gathers some speed”, says Capital Economics.

The US certainly looks in better shape than any of its competitors, and that has prompted the Federal Reserve to begin tapering its quantitative-easing programme.

While it is still loosening monetary policy, albeit more slowly, it looks set to raise interest rates far earlier than the European Central Bank or the Bank of Japan. They look more likely to step up or begin money printing rather than head towards tightening.

Relative expectations for economic growth and monetary policy are a key driver of exchange rates. The higher the short- or long-term interest rates on offer in a country, the more appealing holding its assets becomes.

The US is closest to raising interest rates, which is positive for the dollar. Long-term interest rates are also likely to rise as the economic backdrop improves.

Another effect of tapering and the prospect of eventual monetary tightening is to prompt money to leave riskier assets, such as emerging markets, and head back to the US. So emerging-market currencies are also likely to weaken against the greenback.

Another tailwind is a structural improvement in America’s current-account deficit. This external deficit had reached 6.2% of GDP in 2005, a sign of a country “living dangerously beyond its means”, says The Economist.

A large external gap implies a weaker currency, which is needed to correct the deficit: if exports get cheaper and imports more expensive, the trade gap will shrink. But America’s current-account gap is down to around 2% of GDP largely because shale oil has reduced oil imports.

Add this all up, and Morgan Stanley reckons that the greenback, now at $1.36 to the euro, will hit $1.24 by the end of the year.