The US election outcome suggests a stronger dollar

The key determinants over a 6-to-12-month horizon for an exchange rate between two currencies are the differentials in interest rates and expected returns for assets. Over the long-term, the key determinant is the so-called purchasing power parity. It measures the exchange rate that equalizes the price of a representative basket of goods when calculated in dollars.

The US election results changed the economic environment. Depending on the focus that the new President will put on the announced policy measures, inflation could rise again. We now expect a higher terminal rate for the US central bank while the opposite is true for the ECB. The expected return for US equities has been revised up for the coming year. We thus revised our outlook for the USD with a 12-month target for the EURUSD (value of one euro) at 1.02. This suggests more strength for the USD relative to our previous scenario. This conclusion is valid for several other exchange rates against the USD.

For most exchange rates, the dollar remains overvalued relative to the long-term fair value estimate when we use the purchasing parity. Over previous decades, such deviations have sometimes lasted over several quarters. That could also be the case this time.