Is the US dollar’s long climb about to end? And, if so, where should you put your money?
- Neal Kimberley says market watchers are on the alert for a slide in the US dollar, and Asian currencies may be the ones to benefit when the time comes, although that may not be before 2019
Is King Greenback’s crown slipping? There is a narrative that suggests US dollar strength may be about to turn to weakness. If true, the trick for investors will be to identify those currencies that would gain most as a result. Asian currencies could be prime candidates. But there’s also the question of timing.
Simon Derrick, chief currency strategist at US bank BNYMellon, highlighted last week how Federal Reserve chairman Jerome Powell has recently enumerated a number of headwinds facing the US economy. For example, Powell alluded to some weakness in the US housing market which, at least in part, may be attributable to higher mortgage costs in the wake of Fed rate hikes.
Markets have rationally begun to contemplate the possibility of fewer future Fed rate hikes than are currently priced and to explore the ramifications for a US dollar whose attraction has been enhanced by rising US yields in the wake of prior hikes.
France’s Credit Agricole CIB wrote on Friday that “the more cautious tone struck by several US policymakers recently has corroborated market expectations of a pause in the tightening cycle once the Fed has brought rates closer to neutral”. The greenback’s “recent lack of form may signal a turning point that may usher in the end of the reign of King [Dollar] in coming months”, the French bank argued.
Powell has not been the only Fed official to adopt a seemingly softer tone. Vice-chairman Richard Clarida and Dallas Fed president Robert Kaplan have both recently expressed views that would imply a more data-dependent approach to further rate hikes.
With an eye to specifics, Derrick feels “this change in tone from the Fed might be enough to relieve the pressure on the [Chinese yuan]”, noting that “this may already be happening...”
Additionally, observing how Chinese equity indices have been relatively calm compared to US markets in the past few weeks, Derrick also noted that other currencies have also picked up.
He notes that currencies which have shown a high correlation with the CSI 300’s performance since summer have either, as in the case of the Taiwan dollar and the South Korean won, stabilised against the US dollar, or have begun significant recoveries from the lows of late October – here he cites the Indonesian rupiah, Australian dollar and Indian rupee.
The Japanese yen might be another major beneficiary if the US dollar loses its broader allure. Traders will have noted the recent announcement of Japan’s US$1.5 trillion Government Pension Investment Fund that it is now able to hedge its foreign currency exposures, if it so chooses.
If the US dollar’s fortunes do start to wane, the arguments for such hedging activity might become louder. As any hedging of the fund’s US dollar-denominated holdings would require the selling of dollars for yen, the market might logically conclude that Japan’s currency would be a significant beneficiary of any broader US dollar weakness.
US bank Morgan Stanley has already nailed its colours to the mast of US dollar weakness, earlier this month titling its FX Pulse research note “Time to Sell USD”.
Whether such US dollar weakness would extend to material gains for currencies such as the euro or the British pound is more debatable. The ongoing spat between the European Commission and Italy over Rome’s budget plans might lessen the euro’s allure while sterling’s fate remains closely linked to the still-unfolding Brexit process.
Proponents of US dollar weakness must also address the issue of position entry timing. Higher US interest rates, combined with quantitative tightening, mean it’s not cheap to fund short US dollar trades and there is a strong possibility that US dollar funding costs might become even more pronounced at the turn of the year.
The post-global-financial-crisis adoption of stringent regulatory capital requirements for “Globally Systemically Important Banks” elevates the importance of end-of-the-calendar-year balance sheet snapshots.
As in previous years, such banks may be less inclined to lend dollars over the end of the year. A currency market positioned for US dollar weakness ahead of 2019 might then find itself paying a substantial cost to fund those trades. Short US dollar positions could be squeezed out.
King Greenback’s crown could slip, and Asian currencies might fill the gap, but this might be more a story for 2019.
Neal Kimberley is a commentator on macroeconomics and financial markets