Alfonso Peccatiello, the Netherlands-based CIO of Palinuro Capital (a macro hedge fund), posted this chart and accompanying analysis on LinkedIn. It is worthy of note.
The REER is a concept that depicts the dollar (or other currencies) in a form where the price of a good or service is adjusted for differences in inflation and other factors that are at work in one national economy versus another national economy. The concept is that there is a single global price for a service or good that is identical in each location or jurisdiction — if markets could clear to that price without interferences or obstacles. So, if the price is not presently reflecting that concept, then economic forces will pressure prices to converge. That doesn’t mean they will ultimately converge; it means the directional pressure is on them to converge. The interference of governments and the frictions of financial markets are the obstacles to a single-price rule.
American policy is now oriented toward a weaker dollar. That is both a stated policy (President Trump and his economic counselors repeat it and repeat it) and also a policy at work, because the United States is headed for the issuance of additional trillions of Treasury debt as a consequence of the passage of the Big Beautiful Bill. The buyers of that debt need the US dollar to pay for it.
Americans get their dollars internally. Foreigners get their dollars from the US trade deficit, which is now the target of Trump’s tariff policy. The flip side of the trade deficit is the capital account surplus. That surplus is how foreigners use the dollars they accumulate to purchase US debt and anything else in America. They can buy weapons, and they are doing so in a big way. They can take vacations to America, but many are electing not to come here because of the fear induced by the ICE stories. They can send their kids to American schools; but that option, too, is under attack.
So, an adjustment is underway because of the shift in pressures. The question is, where is the REER heading in the future?
IMO, the chart shows the beginning of a large multiyear trend of dollar weakness. This is not a blip. It is a major trend change.
I agree with Mr. Peccatiello’s assessment. Here’s what he wrote:
Trump won’t stop until he achieves this. The US Dollar just had its worst start of the year in many decades. And it could get worse going forward.
In the first 6 months of the year, the Trump administration has clearly shown its true colors. The overall economic agenda is based on the idea that the US Dollar is way too strong because foreign countries have “ripped off America’’ for decades, and there are only 3 ways to fix this:
1) The US should consume less hence not offering the demand necessary for countries to export a lot.
2) Roles should reverse, and foreign countries should engage in big fiscal and boost domestic demand.
3) The US unilaterally weakens the USD so much that it acts as the rebalancing mechanism itself.
Option 1 and 2 are very hard to achieve, and hence the Trump administration has resorted to option 3: a unilateral weakening of the US Dollar via tariffs, attacks on the Fed independence, and major uncertainty injections for foreign investors.
How weak should the US Dollar be to mechanically “rebalance” this system? The chart below shows the REER (real effective exchange rate) valuation for the US Dollar going back 40 years. The REER is a simple FX valuation metric that looks at the currency against a basket of peers, and it also takes into account inflation. The idea is very simple: the fair level of a currency pair is the one that doesn’t allow for any difference in the true underlying price of a good sold in either of the two countries (as postulated by the Purchasing Power Parity and the Law of One Price).
According to this model, the USD is still 10%+ overvalued.
Alfonso Peccatiello concludes his post on LinkedIn with the following questions for readers — correct ones, I think:
“Where do you think the US Dollar could go? And have you prepared your portfolios for potential currency impacts?”
