Volatility the watchword for dollar as US economy back in focus
With improving market conditions, US monetary policy is starting to overshadow China’s economy as a key determinant of investor sentiment
At the beginning of this year, mounting concerns about China’s economy were the most important determinant of investor sentiment.
The conduct of US monetary policy – which has had a huge bearing on the performance of the dollar as the Federal Reserve begins to normalise financial conditions just as the world’s other main central banks keep loosening policy – played second fiddle to China and the sell-off in commodity markets as the main driver of sentiment.
Yet now that market conditions have improved, with the US S&P 500 equity index surging 11 per cent since mid-February (its biggest gain over a six-week period in five years), US monetary policy has come back into focus.
Speculation is growing that the pace of monetary tightening will be even more gradual than the Fed anticipated when it raised interest rates for the first time in nearly a decade last December.
On Tuesday, Fed chair Janet Yellen delivered an extremely dovish speech in which she stressed the need for the US central bank to “proceed cautiously” in raising rates, pointing to the “more uncertain” outlook for inflation and persistent risks in China and commodity markets.
Global equities rose following Yellen’s address, the policy-sensitive yield on the 2-year Treasury bond fell further to 0.78 per cent and investors pared back their expectations regarding the timing of the next rate rise, with only a 53 per cent probability assigned to an increase as late as November.
For currency investors, Yellen’s comments, which lie in stark contrast to the more hawkish pronouncements by several Fed policymakers in recent weeks, inject yet more volatility into the performance and outlook for the dollar, a crucial determinant of sentiment.
The dollar index, a closely watched gauge of the performance of the greenback against a basket of its peers, is now close to a five-month low after rising 1.6 per cent between March 17 and 25.
This brings the dollar’s decline since early January to 4.5 per cent after having surged 25 per cent between mid-2014 and March 2015 when markets were anticipating a sharp divergence in monetary policy between the US central bank and its European and Japanese counterparts.
Societe Generale believes the “sun is setting on the dollar’s rally”, while Morgan Stanley notes that “Yellen has opened the door [to] further dollar weakness in the short-term”.
The dollar’s Fed-induced retreat will bolster the recent improvement in sentiment towards so-called “risk assets” – particularly emerging markets (EMs) – and provide a fillip to dollar-denominated oil prices.
Once again, the Fed is coming to the rescue of volatile and fragile markets, lending more credence to the view that financial vulnerabilities are making it extremely difficult for the Fed to raise rates. SLJ Macro, a hedge fund, believes the US central bank’s policies are influenced less by US economic data and more by developments in markets.
So where does this leave the dollar and is the Fed’s more dovish stance likely to help sustain the market rally?
o be sure, the greenback’s bull run ended quite some time ago. The dollar’s decline in March, its sharpest since September 2010, takes the drop in the index over the past year to 3.4 per cent. Yet during this period, many EM currencies have suffered much sharper falls, showing the extent to which other factors, notably China’s slowing economy, have had a stronger bearing on sentiment.
Still, an increasingly dovish Fed undermines the monetary divergence trade and removes the most important prop for the dollar, not least given Yellen’s own admission this week that further rate increases are contingent on an end to the dollar’s appreciation which has hurt the US manufacturing sector and suppressed consumer prices, making it more difficult for the Fed to meet its 2 per cent inflation target.
As the latest Bank of America Merrill Lynch (BAML) Global Fund Manager Survey revealed, “long dollar” positions remain one of the most crowded trades, suggesting that there is significant scope for these positions to be unwound, leading to further weakness in the dollar in the coming weeks.
However, given the Fed’s notorious flip-flopping on the timing and pace of monetary tightening, the mostly likely scenario is that the dollar remains volatile.
More importantly, there are plenty of other factors that could – and already have – unsettle markets, particularly renewed strain on commodity markets.
Indeed, the fact that it is now the Fed which is buoying sentiment is worrying in itself at a time when market confidence in central banks is waning.
Nicholas Spiro is a partner at Lauressa Advisory