A dollar rally few are prepared to call time on
US currency is expected to maintain its momentum but medium-term risks remain
Buoyed by the strong US economy, the Federal Reserve’s rate increases and lacklustre growth elsewhere, the dollar has rediscovered its momentum over the past six months. And analysts believe that the rally has further to run for now.
After a weak 2017 and starting the year on the back foot, the dollar has strengthened more than 5 per cent against many of its peers since April. In trade-weighted terms, its gains have been even stronger.
While emerging markets have had some respite in recent weeks, the effect of dollar strength on EM has been ugly. JPMorgan Chase’s EM currency index has tumbled 12 per cent since April, with equity markets, as measured by the MSCI Emerging Markets Index, surrendering more than 16 per cent.
The dollar’s surge — and why it might take a few, final strides higher — boiled down to “US exceptionalism,” said Daniel Hui, a global currency strategist at JPMorgan.
On most measures, the US economy is still outperforming the rest of the world, while the outlook elsewhere looks much dimmer. The IMF this month lowered its forecasts for global economic growth for this year and next, following a downward revision for the euro area and many emerging markets.
Given the robust pace of US economic growth, the Fed has continued to tighten monetary policy. At its September meeting, Fed chairman Jay Powell teed up another rate increase in December, the eighth this cycle, and the median interest rate forecast by the Fed’s policymakers signalled an additional three rises in 2019.
While the Bank of Japan has recently tweaked its monetary policy, and the European Central Bank plans to end its bond-buying programme by the end of the year, neither have indicated they will follow with interest rate increases any time soon. For Daragh Maher, head of US foreign-exchange strategy at HSBC, the dollar’s rally feeds on this divergence, as higher rates suck in capital from abroad.
“Many central banks around the world have delayed or pared back expectations of when interest rate hikes will begin and how high rates may go,” he said. “Whereas in the US, the Fed is likely to continue defying the market’s dovishness and hike beyond the ‘neutral rate’.”
Investors remain sanguine about this risk. According to Fed funds futures, which are contracts investors use to bet on interest rates, the implied odds of three rate increases or more in 2019 is relatively low, at roughly 25 per cent. In fact, almost 40 per cent believe the Fed will only lift rates once more next year — or stay pat entirely.
Emerging markets currencies have regained some tentative stability lately, but the outlook clouds quite dramatically if the Fed commits to faster interest rate increases.
“Emerging markets are very vulnerable to the Fed,” said Stephen Jen of Eurizon SLJ Capital, a hedge fund. “The cheap capital that pushed in after those years of quantitative easing was never loyal. The stronger the US economy, the quicker dollars are sucked out.”
Moreover, those dollars often end up on American shores. With the deepest pool of safe assets for foreigners, the US serves as a haven during periods of economic and financial distress. Add to that the large “structural short” of dollars around the world, given the greenback’s role as the global funding currency, and dollar strength should beget even more of the same, argued Calvin Tse of Citigroup.
The dollar’s recent vim is not immutable, however. Analysts warn that the medium-term outlook is looking murkier with several impediments that could trip up or reverse the rally.
One concern is that the Trump administration’s fiscal stimulus is beginning to wear off. The IMF might have trimmed its global growth outlook, but its US forecast also took a hit, and more investors are now talking about a coming economic inflection point.
The hangover could be larger and come faster than many expected, warned George Saravelos of Deutsche Bank.
US tax reform resulted in offshore corporate cash piles being repatriated, which companies then used to buy back a record amount of their own shares — a move that Mr Saravelos called “one of the largest risk transfers in the history of financial markets”. Pension funds, which had been overweight equities, then rotated into long-dated US bonds, providing something akin to quantitative easing. But the impact is now fading.
“It’s a one-off deployment of cash,” Mr Saravelos said. “We saw a large increase in short-term inflows from it, but if you look at the medium-term drivers of the balance of payments, there is no rise in M&A or portfolio inflows.”
The dollar could also come under pressure if the US economy slows enough for the Fed to hit pause. Any indication of a rebound in European growth or a boost in Chinese domestic demand stemming from efforts to restimulate the economy could also cut the dollar’s rally short.
Stretched investor positioning also looks like a risk. Net long positions for leveraged funds now total almost $27bn, according to CFTC data. That is not a record high, but it remains quite steep.
Viraj Patel at ING estimated that a large adjustment or clearing out of these positions could result in a 5 per cent drop in the US currency. “The dollar’s rally is really getting uncomfortable now,” he said, even if few are prepared to call time on it yet.