Buck Down to Earth

Is recent U.S. dollar weakness a resumption of the downtrend that started at the end of 2016?

Today’s CIO Weekly Perspectives comes from Fixed Income CIO Brad Tank and guest contributor Ugo Lancioni.

The newly dovish stance of the Federal Reserve, the recent surge in the price of gold and Bitcoin, a string of weak U.S. economic data releases—there has been a lot to rouse the U.S. dollar bears lately. The dollar index is down some 2% since the end of May. Is it about to resume the downtrend that started at the end of 2016?

We tentatively side with the bears. But the dollar is subject to particularly complex cross-currents right now. The strongest of those currents is perhaps the U.S. administration’s long-term strategy to bring manufacturing back to America—which makes the weekend’s meeting between Presidents Xi and Trump an important event for the dollar in itself, as well as a key determinant of global risk appetite. Then there is the relative direction of economic performance in the U.S. and the rest of the world, and the effect of that on interest rate differentials. And finally there is the question of what the dollar will weaken against, if it weakens at all.

Risk Appetite

When you read this, we’ll know the outcome of Saturday’s talks between U.S. and Chinese officials on the fringes of the G20 meeting in Japan. For the dollar, in the immediate term this is all about global risk sentiment.

If there is progress, the safe-haven trades that many investors hold could begin to unwind. We might expect the dollar to strengthen against the Swiss franc and the Japanese yen, because relative to these the high-yielding dollar is not a haven currency. It could weaken, however, against procyclical G10 currencies that have experienced softness recently, such as the Australian and New Zealand dollars, and against undervalued Scandinavian currencies where growth and inflation data supports the case for higher rates. We would likely see the reverse of those moves if talks have disappointed, as that would imply a period of uncertainty in which the Federal Reserve is forced to cut rates into the end of the year.

On balance, one might expect a risk-on environment and dollar weakness to benefit emerging markets currencies, and vice versa. At the moment, however, growth concerns in these economies lead us to a neutral view overall.

Indeed, in the absence of an extreme outcome from the talks, we would expect any move against the dollar to be gradual. The U.S. dollar real effective exchange rate is certainly expensive, but still far from the extremely stretched levels recorded in 2002, during the tech bubble.

Long-Term Dynamics

It’s worth remembering what these U.S.-China talks are all about. The U.S. wants to bring manufacturing back home. To do that it needs to achieve agreement in trade talks (which would be positive for the U.S. economy but also for global risk appetite), and it also has a preference for a competitive exchange rate. On balance, that argues for dollar weakness from here—hence President Trump’s barbs against Jerome Powell and his desire to have “Mario D” and his negative rates at the Fed.

If those long-term dynamics are reinforced by soft U.S. data in the medium term, as the fiscal stimulus of 2018 begins to fade, that would give the Fed cover to follow the markets and deliver rate cuts. Pressure on the dollar would only grow. We got the weakest ADP employment number since the financial crisis three weeks ago, quickly followed by very soft non-farm payrolls data for May. The latest interim U.S. Purchasing Managers’ Index release undershot expectations and showed factory activity stalling. It is these kinds of print that have dragged the greenback down from its recent peaks.

Stabilization

What does all of this mean for the key EURUSD rate?

So far this year, this rate has been range-bound, pushed and pulled by the current account balance in favor of the euro on one side, and the extreme interest rate differential in favor of the dollar on the other.

There are signs that the rate differential, which has made the dollar such an attractive source of carry and such an expensive short position for two years, is narrowing. Since its peak in November, the one-year yield gap has already narrowed by about 80 basis points, from about 320 to about 240. Were we to get all of the Fed rate cuts that markets are pricing in, the dollar is likely to adjust lower.

That is partly because the European Central Bank, where policy rates are already negative, has less scope for cuts than the Fed. We may also be seeing some stabilization in euro zone economic data and the beginnings of a growth reconvergence. That disappointing flash PMI release out of the U.S. was paired with a slightly better than expected print from Europe, for example.

Given the moderate long-term valuation of the euro relative to the dollar, these dynamics certainly imply room for EURUSD to drift higher. The dollar is still the outlying high-yielder among the G10 currencies and as a result the market still appears to be long—but that just makes it more vulnerable in the event of further tightening in rate differentials. The bears may be onto something.