The US dollar might have a surprise move in store that will crush expectations
Bearishness on the US dollar has reached an extreme, leaving open the possibility of a pronounced rally
As recently as late November, the dollar index, a gauge of the currency’s performance against a basket of its peers, stood at a 12-year high amid speculation that US monetary policy would diverge significantly from the trend in Europe and Japan, with the Federal Reserve raising interest rates for the first time in nearly a decade and the European Central Bank (ECB) and the Bank of Japan (BOJ) undertaking aggressive quantitative easing (QE) programmes.
Since then, the index has fallen 7 per cent to a 16-month low. US benchmark 10-year Treasury yields, moreover, have dropped more than 40 basis points to 1.77 per cent, their lowest level since January 2015.
The dollar’s sharp decline this year - the index is still 16 per cent stronger than in mid-2014 - has undermined the “monetary divergence” narrative and turned what was until recently the most “crowded” trade, according to the latest Bank of America Merrill Lynch (BAML) Global Fund Manager Survey, into one of the biggest pain trades.
The currency’s slump stems from the more dovish-than-expected stance of the Fed which has scaled back its interest forecasts to two quarter-point increases this year because of increasing concern about global financial and economic developments.
While the dollar began to rise again on Tuesday following hints by two Fed policymakers that a rate hike next month was possible, bond investors believe there is little scope for a further tightening in policy this year, with futures contracts assigning just a 12 per cent probability to a rate increase next month and a 55 per cent probability to one in December, according to Bloomberg.
The weakness of the greenback is creating huge shifts in the global financial landscape.
The biggest winners are emerging markets (EMs), with the currencies of developing economies rallying sharply over the past several months. The Bloomberg JP Morgan Asia Dollar Index, which tracks the performance of Asian currencies (with the exception of the yen) against the greenback, has shot up 2.7 per cent since mid-January, having tumbled more than 10 per cent between September 2014 and the start of this year.
JP Morgan notes that EM currencies have enjoyed their “best period of performance since the [dollar] bull market began in 2013, with more recent fuel coming from a dovish Fed.”
The dollar’s decline has also buoyed other dollar-sensitive assets, in particular commodities, with oil prices rising more than 50 per cent since early February. Gold, meanwhile, has also benefited from the dollar’s weakness, enjoying its best start to the year in three decades.
The losers are the countries most reliant on weaker currencies in order to help them reflate their economies.
The biggest casualty of the greenback’s depreciation is “Abenomics”, the reflationary programme of Japanese premier Shinzo Abe which has been heavily reliant on a weak yen to help put an end to a long period of entrenched deflation.
The dollar’s slump has contributed to a nearly 12 per cent rise in the yen versus the dollar since the end of January, undoing part of the currency weakness which underpinned confidence in Abenomics. Not surprisingly, Japan’s export-sensitive stock market has dropped a further 15 per cent this year, heaping pressure on Japanese policymakers to intervene to weaken the currency despite a recent pledge by the G20 group of economies to stabilise foreign exchange markets by refraining from competitive devaluations.
Another casualty of the dollar’s decline is the eurozone whose fragile economic recovery over the past few years has stemmed in part from a 25 per cent fall in the value of the euro against the greenback between March 2014 and March 2015 as investors anticipated the launch of full-blown QE by the ECB.
Europe’s single currency has risen more than 8 per cent versus the dollar since the end of November, with the bulk of the decline occurring since the end of February in the face of further stimulus measures from the ECB.
Still, while further weakness in the dollar is likely in the short-term, monetary divergence is not dead.
The fact remains that the Fed is still likely to raise rates later this year, and may do so as early as June if markets continue to remain stable and US economic data improves.
Given that the dollar is ultra-sensitive to Fed policy, the greenback’s slide could easily give way to renewed appreciation if speculation about a June rate hike becomes more pronounced.
For now, however, dollar “bears” are in the ascendant.
Nicholas Spiro is a partner at Lauressa Advisory