Dollar rally will run out of steam

The US dollar (USD) has seen a startling rebound over the last month, with implications across asset classes. As former US Treasury Secretary John Connally once said: “the dollar is our currency, but your problem”. For markets, the problem is working out when and where the rally will end. We believe the gains have occurred for a variety of reasons, some of which are technical, and we expect an eventual tapering off as the market takes a fresh look at fundamentals.

Few options

It is no accident that the USD has gained around 4% in trade-weighted terms from its April low just as US 10-year Treasury yields have risen above 3%. The market loves psychological thresholds and they can end up being self-fulfilling prophecies.

Increases in US yields have historically foreshadowed USD strength. And in this case, the trend is underpinned by a lack of confidence in the other options: witness the stubborn refusal of German 10-year Bunds to break decisively above 0.5%.

The US has the only hawkish-looking central bank and an economy that is motoring along, if not turbo-charged. In other words, a momentum trade on the USD is being encouraged by doubt about growth and inflation elsewhere and about the path of rate hikes from both the European Central Bank and the Bank of Japan. This even makes the dollar start to look like a home for cash balances, and we feel that our underweight on US cash is no longer justified.

We have slightly adjusted our currency forecasts to account for a temporarily strong USD. To reflect this, we have lowered our forecast on EUR/USD from 1.25 to 1.23 on a 12-month view and from 1.22 to 1.20 over three months. We think that the structural trends we have identified remain in place, although they may be postponed by a few months. Our base case is for sustained global growth, which would gradually see output gaps close, and as a result other central banks’ policies will edge closer to that of the US Federal Reserve (Fed). That means the euro (EUR) and yen (JPY) are still likely to appreciate on less accommodative monetary policies, but that timing has now been pushed later in the year.

Wriggle room

The US economic cycle is at a more advanced stage than its peers, and the Fed far more advanced than other central banks down the path of monetary policy tightening. That does not yet mean that conditions are restrictive: real rates in the US (short-term interest rates minus inflation) are at 0.9%, giving the US economy at least a little wriggle room before conditions start to look difficult. However, it does mean that the room for expansion is limited. We do not see the opportunity for the US economy to increase its pace of growth, nor do we see 10-year yields heading towards 4%, although as much as 3.5% is now in our range.

In mid-April, EUR/USD stood at 1.24 and this week it trades around the 1.17 mark. The USD/JPY has moved from 107 to as much as 110 over the same period. We believe this trend will be capped at about 1.15 for the EUR and 115 on the JPY.

At these kinds of levels, we should see only a modest impact on emerging markets. Typically, emerging equities have suffered in a strong dollar environment as their debt (and sovereign paper) tends to be held in USD. There remain risks to EM if this currency environment is sustained, but given our base case for USD, improving EM fundamentals and the relative youth of the EM economic cycle, we strongly believe that emerging markets may deliver further upside.

Trade questions

At the most basic level, currencies are a yardstick for a nations’ relative health, but their movements also help to dictate the shape of global trade.

It is worth noting that President Donald Trump has little use for a strong USD, even if it adds some lustre to his populist and protectionist political narratives as mid-term elections approach. A slight weakening of the USD from current levels would work in his favour, making US exports cheaper just as trade negotiations gather pace. That helps to support our base case for an eventual weakening in the USD from here. Two years ago the US currency was clearly undervalued, now we believe it is marginally overvalued.

Looking more broadly, a US trade deficit has tended to act as a headwind to the USD. The recent noises from Washington to cut that deficit with China have perhaps added to the USD gains, but have also fuelled fears of an escalation in tensions which could undermine US, and in turn global, growth.

However, our central scenario remains unchanged. There is a pattern in US diplomatic moves of initial bluster quietly followed by a more rational compromise. Markets are becoming used to this form of transactional posturing, and in the case of China, its leaders are being encouraged down a path that suits their longer-term trajectory -- towards a more open, services-led economy.

Back in 1971, when John Connally told the leaders of developed countries that his currency was their problem, it was part of a political push to reset the terms of global trade and define new global relationships for the US. Connally’s brash style helped spark a sharp and lengthy decline for the dollar as the so-called “Nixon shock” took hold. Although the political dynamic is intriguingly similar, we don’t expect anything quite so dramatic this time. The dollar will certainly weaken, but without the shock.

Data as of 25 May 2018