Friday, 20 July 2018

Too early for dollar bulls to hibernate (free content)

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Shah: We still see a break of parity on euro/dollar by year-end.

The market is providing another reminder that FX rates don’t move in a straight line, especially when expectations and positioning are excessive.

While the dollar rebound has caught traders off guard, the stark policy divergence between the Fed and other central banks means the US dollar will remain biased toward strength.

Key to this is the Fed’s conviction that inflation will move toward its 2% goal, which keeps alive the Fed’s lift-off/normalization script and reinforces the US dollar’s role as an asset.

We would characterize the state of play in FX markets as having five* distinct camps:

  • 1) seeing a loss of confidence and thus attempting to keep a lid on currency weakness: see Russia or Turkey
  • 2) trying to actively prevent currency strength: Denmark and SNB
  • 3) central banks talking down their currency or indicating a preference for a weaker currency: RBA, RBNZ, BoC
  • 4) an easing bias and China/inflation outlook allowing some CBs to relax policy: RBI, BoK, BoT and BI
  • 5) favouring a weaker currency from an inflation perspective and willing to actively use monetary policy: ECB, BoJ and Riksbank

Given the long list of central banks averse to currency strength, either directly or indirectly, the only place left to run is toward the US dollar.

So far, the Fed and Treasury have tolerated this bout of US dollar strength as a byproduct of monetary policy easing rather than countries engaged in competitive devaluations (so called ‘currency war’). This tolerance will not change as long as central banks continue to act based on their own national mandates. The Fed is simply joining this group of central banks that are increasingly cognisant of the currency impact on inflation.

While the US Treasury will stick to its bias toward a ‘strong dollar’ (that old byproduct of the Rubin era), the Fed has recently shown more caution. Officials have creeping worries that continued US dollar gains could make it difficult for it to achieve its 2% inflation goal. These concerns are still in their infancy. But with the FOMC having now lowered its assumed NAIRU levels to near 5.0%, further US dollar strength will likely lead to a lower expected rate path.

While the Fed’s concerns over the dollar will impact the speed of travel, the direction of travel is still towards policy normalization and a rate lift-off before year-end. With the Fed removing the tail risk of an aggressive tightening cycle, we should see greater diversification on US dollar FX rates. US dollar gains will be increasingly driven by the policy outlook for other central banks.

Yield differentials and monetary policy divergence should still see a lower euro/dollar, just not at the same torrid pace seen since the start of the year. We still see a break of parity on euro/dollar by year-end and the potential for a test of its 2000 low of 0.8225 ahead of September 2016 when ECB QE ends.

*Corrects the number of central bank camps to five from four.

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