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Why 2018 could be a year of great promise for the US dollar

Tax cuts, tighter monetary policy and widening bond yield spreads could all make next year a good one for the US currency

PUBLISHED : Monday, 11 December, 2017, 3:45pm
UPDATED : Monday, 11 December, 2017, 10:45pm

It is no exaggeration to say 2017 has been a tough year for US dollar bulls. Disappointments over US President Donald Trump’s promise to deliver radical reforms and past policy dithering by the US Federal Reserve have rained heavy blows on US currency optimism for much of the year. But if 2017 was the year of deep dollar disappointment, 2018 should be the year the dollar comes up trumps.

The currency’s luck is changing. The first hint of success on Trump’s much-vaunted tax overhaul was a welcome relief for the currency, but this week should see more good news with the Fed toughening up on US monetary policy. Wednesday’s Fed rate policy decision should be all important, with another quarter point rate rise priced in.

For currency traders, placing successful bets is a perennial problem, generally down to picking the best of a bad bunch. It’s true now, as most currency majors are fraught with problems and riddled with risk. The dollar has been thumped by super-loose monetary policy, the euro haunted by debt default risks, the yen is suffering from years of deflation neglect and the British pound is being battered by deep-rooted Brexit fears.

Fed chief Yellen says US economy healthy enough for more rate increases

For years, forex speculators have had to grapple with acute political risks, financial crises and impending economic doom. Safe haven plays into ultra-safe bolt-holes like the Swiss franc might have kept sleepless nights to a minimum, but traders have paid dearly for it in terms of negative carry costs. Striking gold on currency bets is only down to smart thinking, good timing and a pinch of good luck.

Riding the bow-wave of impending apocalypse back in 2008 was a white knuckle ride for most investors, but extreme volatility and roller-coaster price action was also a godsend for the brave-hearted who got their timing right on wild market moves. In the current climate of muted volatility, super-low interest rates and wafer thin bond yields, currency gambles are much more challenging.

Traders needn’t fret too much as the laws of relativity provide some pretty good clues going into 2018.

US economy grows at its fastest pace in three years

Whatever political storms encircle the White House right now, most of the bad news has already been factored in and short of a damaging impeachment battle the dollar should see good upside potential next year, helped along by greater policy divergences emerging between the US, euro zone and Japan.

Widening interest rate and bond yield differentials should weigh heavily in the dollar’s favour in coming months, thanks to the US’ tighter monetary and looser fiscal policy mix, especially relative to its G3 peers. This week’s US monetary policy meeting should be central to this as the Fed launches into the next phase of interest-rate tightening and fleshes out more detail on its asset tapering plans.

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With interest-rate expectations picking up in the US, policy rates in the euro zone and Japan continue to flatline, especially while sustainable recovery hopes seem unsecured in both economies. The European Central Bank is in lockdown on rates for a long time, while its bond-buying operations should extend for most of next year, possibly even into 2019. The Bank of Japan’s super-easy stance seems set in stone.

Trump’s tax reform plans should be good news for US growth prospects and provide a vital boost to the dollar too. US bond market bears may be fretting about the negative impact on the budget deficit, future debt levels and treasury yields, but what is bad news for bonds should provide added appeal for the dollar as US yields rise and yields stay relatively subdued in Europe and Japan.

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As short and longer-dated yield spreads continue to widen in the US’ favour, the dynamic for a stronger dollar should improve by leaps and bounds. It is already evident in the money market curve, with three-month US interest rates offering 170 and 130 basis point premiums over rates in the euro zone and Japan. Those spreads will widen even more as the Fed keeps cranking up the rate policy handle.

Meanwhile, at the back end of the yield curve, the deck is even more stacked in the dollar’s favour with 10-year US Treasuries yielding around 220 and 190 basis points over equivalent bonds in Europe and Japan. It’s a big pulling point for investors.

A tougher talking Fed could be music to the currency market’s ears this week and give dollar bulls a much-needed head start in 2018.

David Brown is chief executive of New View Economics

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