Overvaluation of Greenback May Be Nearing Its Limits, BNY Says

(Bloomberg) -- The overvaluation of the U.S. dollar might be close to its peak, while China's currency has continued to climb even further above its so-called fair value level, according to Bank of New York Mellon Corp.

Accelerating global inflation is likely to spur a more hawkish response from major developed-market central banks outside the U.S., closing the policy gap to the Federal Reserve and reducing one of the greenback's current tailwinds. “This may cap USD overvaluation near current levels,” Daniel Tenengauzer, BNY Mellon's head of markets strategy, said in a note to clients Tuesday.

The Bloomberg dollar index, a measure that gauges the greenback against a basket of peers, has been buoyed by expectations for an even faster tightening of policy by the U.S. central bank and in March reached levels unseen since mid-2020, when pandemic-related concerns were at the fore. Moves on Tuesday underscored that link, with advances in Treasury yields once again spurring the U.S. currency higher.

The U.S. currency is around 5% higher than it ought to be, while the overvaluation of China's -- which has continued to increase -- is around 9.4%, based on a combination of metrics used by BNY Mellon. In Tenengauzer's view, the overvaluation of the yuan -- which has been a feature of the currency for many years -- appears to be more meaningful than that of the dollar.

The Japanese yen, conversely, is undervalued by around 23.7%, while commodity currencies such as the Australian and Canadian dollars are also well below fair valuation, in BNY's view.

Of course, just because a currency is out of line with so-called fair value doesn't mean it cannot become even more so. While models show the yen to be “extremely undervalued,” flow and holdings data show that investors are continuing to be marginal sellers of the Japanese currency, according to BNY. And that dynamic is clearly evident in the price, with the yen down close to 7% this year against its American counterpart.