Finally, some US dollar strength. How much further can it go?

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After months of weakness relative to both major and emerging market currencies, the US dollar has rallied in April

Exhibit 1: The US dollar has appreciated recently, notably versus emerging market currencies – the graph shows US dollar relative to a basket of G10 currencies (lhs) and a basket of EM currencies versus the US dollar (rhs, inverted).

US dollar strenghtens versus emerging market currencies

Source: Bloomberg, BNP Paribas Asset Management, as of 01/05/2018

In our view, the most likely explanation for US dollar strength relative to other major currencies is that the cyclical recoveries in Europe and Japan have fallen short of market expectations, whereas the opposite has been true for the US (Exhibit 2).

Exhibit 2: Macroeconomic surprise indicator stays positive in the US, while it disappoints in other G10 economies (index, 0=no surprise)

Source: Bloomberg, BNP Paribas Asset Management, as of 01/05/2018

In other words, the data in Europe and Japan has not been strong enough to convince investors that the ECB and the Bank of Japan (BoJ) will sound more hawkish anytime soon. By contrast, the solid, if unspectacular, data in the US has been enough for the rates market to continue to price in higher US front-end yields (Exhibit 3).

This contrasts with European markets where the growth prospects have softened and core inflation has remained subdued. In the eurozone, for example, cyclical indicators such as the Purchasing Managers’ Index (PMI) have weakened after months of strength. In the UK, growth has disappointed. Q1 GDP growth fell to 1.2% YoY compared to consensus expectations of a 1.4% rate. The interest rates markets no longer anticipates a rate hike from the Bank of England in May.

Exhibit 3: US two-year yields rose in April, decoupling from yields in other regions (in bp)

Source: Bloomberg, BNP Paribas Asset Management, as of 01/05/2018

Will this US dollar strength continue?

We believe that some of the US dollar’s strength reflects the weaker G10 (ex-US) data, but it is too early to call for a sustained rally.

After all, the recoveries in Europe and Japan are less advanced than in the US and the ECB and the BoJ have more asymmetric interest-rate paths given their aggressive monetary policy stances relative to the Federal Reserve.

The US dollar has been particularly strong relative to EM currencies

US dollar appreciation has been more aggressive versus emerging market currencies. A strong  US dollar is usually a worry for emerging markets because it may reflect rising US yields which can cause capital to flow out of emerging markets and into US markets.

A stronger US dollar is also associated with weaker commodity prices, which tend to help emerging market commodity exporters. Finally, a stronger dollar may trigger a selloff in emerging equities and local currency debt as dollar-based investors worry about currency losses.

Conclusion: too soon to call for sustained US dollar strength

The moves in emerging currencies have also been sharp because of consensus positions in these currencies resulting in investor complacency. US dollar strength against emerging currencies may persist in the near term as the consensus positions are reassessed. But we believe it is too early to call for prolonged strength. After all, the cycle in emerging economies is strong. It also lags the G10 cycle. Emerging currencies are not being seen as expensive apart from currencies in emerging Asia and, finally, the carry on emerging currencies is still very attractive, in our view.


More articles by Guillermo Felices

Guillermo Felices

Head of Research and Strategy Multi-Asset, Quantitative and Solutions (MAQS)

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