HSBC Forecast US Dollar to Suffer as Currency War Ceasefire is Called

Central Bank inability, or reluctance, to weaken their currencies is radically changing the outlook for most currencies in 2016, particularly against the once all-powerful dollar. 

• “The ECB change of tactics is already pushing the EUR higher, supporting our forecast of 1.20 for EUR/USD at year end."
• EUR/USD must be sold ahead of return of US dollar strength counter Handelsbanken

The US dollar has seen a strong rally over the last few years, the US dollar index rose by 36% from September 2012 to February 2016.

However, it is down by close to 7% since February of this year.

This is confirmation that the rally is over according to HSBC’s leading FX analyst David Bloom.

This news will come as no surprise to those who have been following HSBC's currency sage; he raised some eyebrows last year when he called the end of the dollar's reign.

The call came as dollar buying was still in fashion and questioning the powerful trend made you an outlier.

The narrartive behind the US dollar's change in fortunes does of course change.

Hence, Bloom is back with more insights into the dollar and argues the outlook has gotten worse for the currency as major central banks show an increasing reluctance (or inability) to devalue their currencies. 

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The European Central Bank (ECB) and the Bank of Japan (BOJ) are standout examples of where policy shifts means there is even less reason for the dollar to advance against undermined currencies.

Previously, consensus expectations were the dollar would have a very strong 2016 as a result of the Federal Reserve increasing its interest rates, whilst at the same time other central banks would have to continue easing their monetary policies and keeping their interest rates very low or even in negative territory.

The difference in interest rates – high for the US and low for the rest - would lead to a continuation higher in the dollar index. Currencies tend to appreciate when interest rates are high, as this attracts foreign capital.

Bloom, however, argues the dollar will not see Fed-inspired support because the Fed has backtracked on its initial promise to raise rates by 1.0% over the course of 2016. 

The central bank now envisages raising rates 0.5%.

Furthermore, and importantly, competing central banks have realised cutting their interest rates appears to not have the negative impact on their currencies that was once the case.

Witness, for example, the last two meetings of the ECB, at which they reduced their deposit rates deeper into negative territory on both occasions and threw in a 0.05% cut to their lending rate at the second meeting.

On both occasions the euro actually rose and the dollar fell as a result of the news, although on the second occasion the rise was put down to comments from President Draghi about not cutting rates again.

Nevertheless, the fact that the euro was able to reverse its decline as a result of a single statement by Draghi proved the days when the announcement of increased easing was enough to push the euro lower by over a hundred points have gone.

Central Bank 'Ceasefire' to Undermine the USD

Central banks may have changed their strategy to deliberately avoid depreciating their currencies in what had previously been a “currency war”, argues Bloom:

“We believe a truce has broken out in the global currency war. Both the ECB and BoJ seem to have changed tactics. The BoJ cut rates into negative territory rather than just expanding QE and the ECB have switched to using the credit channel rather than blindly trying to drive the EUR lower.”

It is debatable whether central banks have deliberately changed tactics to avoid a currency war, or whether the policies which previously weakened their currencies simply have stopped working, however, the upshot is a lack of down-side potential for the euro, yen and other currencies versus the dollar.

The previously expected divergence between the Fed and its policy of increasing interest rates versus the ECB and BOJ’s rate-cutting agenda, now seems both less acute and also of much less impact on the respective currencies dollar pair exchange rate.

Bloom even goes has far as forecasting the EUR/USD to hit 1.20 by the end of the year:

“The ECB change of tactics is already pushing the EUR higher, supporting our forecast of 1.20 for EUR-USD at year end."

The analyst believes central banks in Switzerland and Sweden will start to unwind their accommodative programmes as well:

“In European postcodes such as Switzerland and Sweden, the pressure for ever deeper negative rates, bigger QE programmes or direct FX intervention should fade.”

Bloom concedes there is a risk to his negative-USD view, and that is the currency war flares up agian.

“The FX market is adjusting to a new post currency war reality, one which will further undermine the consensus view of USD strength. While we are giving peace a chance, there is always the risk that it turns out to be a phoney truce. Someone could break ranks causing the current virtuous cycle to become vicious again,” says Bloom.

The Negative-USD Team Grows

HSBC's view echoes that of Credit Suisse, UniCredit, SocGen and ABN Amro who have all argued the same point in modified forms over recent weeks.

ABN Amro's Georgette Boele says the dollar rally is over as her bank updates their exchange rate forecasts.

Like the argument forwarded by HSBC, Boele says much of the USD weakness stems from the dynamics for monetary policy divergence changing this year.

"For a start, the ECB and the Bank of Japan will likely continue monetary policy easing but their policies are not as effective in generating currency weakness anymore," says Boele, "in short, we expect that the BoJ and the ECB will not be aggressive enough to push down their currencies."

UniCredit agree noting major central banks have stepped back from material easing and exchange rate devaluation.

They cite the Bank of Japan's lack of urgency in preventing the recent 8.5% slide in USD/JPY. As well as the ECB's change in communication away from its previous “exchange rate obsession”.

The bank also cites the Reserve Bank of Australia’s and Bank of Canada’s change in stance with them now less likely to cut interest rates.

Credit Suisse, meanwhile, make a similar call to HSBC, saying EUR/USD will rise to 1.17 by year end, due to the ECB changing tactics and not trying to devalue the exchange rate.

They argue that Draghi’s comments about negative rates ‘not going any lower’ were evidence of a change of strategy from the central bank’s governing council away from an 'obsession with exchange rates'.

SocGen’s Alvin Tan, proved right when he said, prior to the ECB meeting, that the ECB lacked the firepower to push the EUR/USD exchange rate below its 1.05 floor.

Handelsbanken: EUR/USD Rallies Must be Sold Ahead of USD Strength

Of course a declining dollar does not represent a one-way bet.

In FX, everyone is usually wrong, but the successful investor knows the risks and balances as many views as possible. The risk, in this discussion is the dollar ends 2016 notably higher.

This is likely say 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.