There is a growing shift in analyst sentiment towards the US dollar with analysts who saw a stronger currency in 2016 throwing in the towel and joining those sages who forecast such a scenario back in 2015.
- UniCredit give four reasons why the dollar's halcyon days have passed
- HSBC and UniCredit long-time dollar bears
- Societe Generale say the dollar index may have peaked
- BMO say hedging ahead of US elections to hold USD back
- DNB Markets, Morgan Stanley and Handelsbanken still forecast stonger dollar
In January 2016 we were questioning whether the mighty dollar would finally crack the 100 ceiling on the dollar basket index. Since February the tone towards the currency has changed notably, with analysts asking whether we are at the start of a much bigger downward cycle.
That is a contentious call, but what is growing increasingly obvious is that fresh highs in the current multi-month cycle of strength may no longer be possible.
The US Federal Reserve tripped the dollar at their March policy decision meeting having revised down their expectations for interest rate rises over coming months.
The US central bank are now suggesting only two rate hikes are likely this year, down from four seen in December 2015.
This is a big deal as a good chunk of fundamental support for the USD has been removed - the very reason the US dollar was such a strong performer in 2015 was because traders assumed it would benefit from higher interest rates in 2016.
These expectations are being questioned and the doubt has only encouraged those that have been forecasting a soft year for the USD over recent months.
“It is not long since the overwhelming market consensus was envisaging a turbo-charged USD for 2016 across the board, with some predicting EUR-USD falling to parity and below. But fundamentals matter. Misalignments from equilibrium can be persistent, but in the end they do correct,” says Dr. Vasileios Gkionakis, Global Head of FX Strategy with UniCredit Bank in London.
Four Reasons why the Dollar’s Days of Strength are Over
We have distilled the arguments forwarded by Gkionakis and his team as to why the dollar is likely to suffer going forward.
1) It is overbought, and therefore trading above levels justified by economics. “What began as a re-alignment with fundamentals, higher US real yields in 2H14, quickly escalated into a frenzy of dollar longs in 1H15, sending the USD sharply higher – much higher than could have been justified by the macro underpinning,” says Gkionakis.
2) Central bank divergence is a dying theme - i.e the Fed looking to raise rates while the rest of the field were looking to slash rates and concoct other methods of stimulus.
This divergence created a USD-favourable scenario whereby markets bought dollars in anticipation if higher US yields while ditching riskier jurisdictions.
On this front, “things are now beginning to change,” argues Gkionakis.
3) Point 3 feeds off point 2: “The Fed is erring towards a more dovish stance than the (already dovish) market expectations. This is a key point, as the dollar could not sustain its gains even with a normal hiking cycle, let alone now with anticipations of an even more gradual one,” says Gkionakis.
4) UniCredit believe other major central banks seem to be stepping back from material further easing and, in certain cases, from the zero-sum game of currency manipulation.
Other analysts agree, Credit Suisse are now suggesting the ECB is abandoning targeting a lower exchange rate altogether.
The governor of the Bank of Canada, Stephen Poloz, meanwhile startled markets by acknowledging that further Canadian exchange rate depreciation would pose risks to the inflation outlook.
In the meantime, the USD-CAD has depreciated by an eye-watering 11%, narrowing a still-wide overvaluation.
UniCredit cite other examples of willingness by central bankers to let currencies batter the dollar:
- the BoJ has done virtually nothing to stand in the way of the material yen appreciation, more than 5% in trade-weighted terms and 8.5% against the USD,
- the RBA has turned perceptibly less dovish and,
- last but not least, last week’s ECB’s communication which represented adeparture from its long-held FX obsession.
Dollar Index has Peaked: Societe Generale
It is worth noting that UniCredit are by no means a lone voice in saying 2016 will not end well for the Greenback.
HSBC have been at odds with market consensus for some time too, back in November we carried a report on their argument that a peak in USD outperformance was nigh.
Societe Generale have meanwhile told their clients to also expect the dollar to underperform.
“Beyond the near-term, the dollar's advance has stalled this year. With the Fed turning cautious, it is difficult to see new cycle highs in the dollar against either euro or yen this year,” say Alvin Tan at Soc Gen.
The dollar index - the basket of the dollar’s biggest pairs - is consequently expected to test key support at 9300/9400 in coming weeks.
At present the index is at 9528.
BMO Capital: Hedging Against Election Uncertainty a Factor
BMO Capital have meanwhile told clients there forecasts for a stronger dollar until mid-2016 appear to have been wrong.
Analyst Greg Anderson says election uncertainty is already playing its part in the USD story as it is inviting 'trigger hedging' that has started earlier than the typically anticipated three month horizon.
There are a number of reasons FX market have already focused on the election.
"Foremost are the Donald Trump phenomenon and his accusations that China, Japan and others manipulate exchange rates for trade advantage. With her opposition to the TPP, Hillary Clinton is also showing a protectionist side, and protectionists normally look to suppress their currencies," says Anderson.
The Republican convention (July 18-21) looks increasingly likely to be contested, which adds to uncertainty. So does the ongoing FBI investigation of Hillary Clinton’s email issues.
"With its potential closeness and these issues, the election looks likely to be a negative factor for the USD until Election Day (08-Nov)," says Anderson.
BMO Capital are forecasting the dollar index to bump along near the January 2016 top, potentially for several years.
DNB Markets, Morgan Stanley: Dollar Strength to Bring About EURUSD Parity
As one can expect, the analyst community is never in agreement.
In fact the views can be quite polarised, which understandably makes treading the foreign exchange markets a tricky prospect for those with an interest in the dollar’s direction.
“Diverging monetary policy will continue to favour the USD. We see a next Fed hike in June and another 2 hikes before year end. More aggressive hikes in 2017,” say DNB Markets in a foreign exchange brief to clients.
DNB are therefore sticking to the once ubiquitous view that the US economy is strong, will stay strong, and will therefore command a higher currency.
The ECB is on the other hand expected to cut the deposit rate by another 10 bps and increase asset purchases in March.
This keeps alive the central bank policy divergence theme which UniCredit reckon is dead; interest rates in the US and Eurozone will continue to widen ensuring renewed buying interest in the dollar.
The 3 months interest difference (EUR-USD) has been unchanged last week. US 2017 FRAs fell 12-13 bps, while similar EMU FRAs have fallen 1-2 bps.
“Our forecast for 1, 3 and 12 months are 1.10, 1.07 and 1.00, respectively,” say DNB on the euro to dollar exchange rate’s outlook.
Morgan Stanley are in the same camp as DNB Markets having also reiterated calls for parity of late.
Interestingly, Morgan Stanley’s argument is that a new threat will take prominence in the FX debate moving forward - that of the perilous state of the Eurozone banks' balance sheets.
Morgan Stanley's analysis assumes a backdrop of constrained global liquidity conditions, caused by repatriation of yen by Japan and a rising dollar, which are likely to make, “creditors more selective about where to place their funds.”
In such an environment Euro-area banks will come up for closer inspection and may be found wanting:
“We think that FX investors will start to become more concerned about the large balance sheets in the European banking sector.”
Handelsbanken: EUR/USD Rallies Must be Sold
The dollar will strengthen argues the FX research team at Handelsbanken in Sweden.
The bank have been long-time dollar bulls and hold some of the most negative GBP/USD forecasts we know of. Unsurprising then that they are advocates of further USD strength.
Both of the Fed’s goal variables – inflation and unemployment – are moving at a steady pace towards their targets.
Analysts say recent inflation figures would argue against further paring back of US interest rate expectations as the core inflation rate has consistently surprised positively.
Despite this, the Fed lowered its inflation rate forecast.
"We see a clear challenge to the Fed’s view in this respect, and still see upside risk in the Fed’s pricing during the year; particularly bearing in mind the recent downturn in short-term interest rates and the steady flow of improved macro data," say Handelsbanken.
The Fed will no longer be able to bearishly influence the USD debate, as a result they advocate selling the EURUSD on strength.