Headwinds for the US dollar

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Federal Reserve (the Fed), ECB, Trump policy and the French election have been among the factors moving the US dollar recently and that could turn into headwinds.

Uncertain: balance sheet reduction by the Fed

Among these, the Federal Reserve has been the most predictable factor as the US central bank has long warned markets that three interest-rate rises are likely in 2017. A new development is that the Fed now expects to start reducing the size of its balance sheet in late 2017. This is significantly earlier than markets had previously thought. Equities reversed a strong rally on the news, while bond yields fell. Some expect balance sheet reduction to cause the Fed to slow its rate rises. Indeed, the Fed will likely tread carefully as the uncharted process starts, given that it is uncertain how this affects markets.

Uncertain: the winner of the French elections

Markets continued to fret over the possibility of a win by Marine Le Pen in France in May, even though recent political developments suggest the worst fears may not materialise. While negative policy rates and quantitative easing by the ECB should continue for the balance of 2017, markets expect more ECB policy guidance by June if current economic trends continue. In the end, central bank driven rate differentials with the US are more likely to drive the euro and the Japanese yen than eurozone politics.

Uncertain: the Trump agenda

More clarity on president Trump’s economic policy regarding trade, tax cuts and infrastructure spending has been delayed well beyond mid-year after the unexpected failure of the repeal of Obamacare. It is possible that gridlock in Washington will continue for much of 2017, deflating some of the optimism that led to strong animal spirits in stock markets, business and consumer confidence.

Uncertain: the need for stimulus

On the other hand, the economy appears to be on a self-sustained moderate growth path both in the US and globally. It could be argued that a large US stimulus at this stage of the cycle is not advisable from the Fed’s perspective, given that inflation and employment are near target already. Barring unexpected negative developments from a protectionist Trump agenda, damaging political developments in Europe, a sharp Chinese slowdown or other catalysts that could cause sharp declines in stock markets and economic activity, a moderate pick-up in world growth and inflation look likely next year.

Uncertain: continued dollar strength

In these conditions the dollar is unlikely to continue strengthening much from current levels. A factor that would be a headwind is the narrowing of growth and inflation differentials and the concomitant reduction in monetary policy divergences. Given that the dollar has rallied by more than 20% in the past five years and now looks quite expensive against many G-10 and emerging market currencies, a risk-aversion event could cause a safe-haven currency such as the Japanese yen to rally sharply.

Certain: precarious dollar levels

The dollar would also be vulnerable against the euro and other cheap G-10 majors (e.g. the Swedish krone). Conversely, should world growth surprise on the upside, EM and commodity currencies would benefit. The long-term position of the real US broad dollar index (see exhibit 1 below) suggests current dollar levels are precarious when US growth is no longer exceptional and world growth is picking up.

Exhibit 1: US trade-weighted real broad dollar indexUS dollar

Source: Bloomberg, as of 31 March 2017

Published on 18 April 2017

Adnan Akant

PhD, Head of Currencies

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