The US Dollar is forecast to lose some ground, particularly against emerging market currencies, over coming weeks argue analysts at Morgan Stanley.
Morgan Stanley's Hans Redeker has written to clients saying the Dollar will find it diffcult to appreciate as US Banks increase the supply of Dollars into the global economy.
Increased supply of a currency tends to lower its value according to classic supply and demand economics.
The commercial banking sector's new-found confidence in exercising their vast balance sheets owes itself to an improving US and global economy.
But, the real spark for this new behiour lies with the Government of Donald Trump’s plans to deregulate the banking sector.
Trump was caught off-guard by the sudden explosive rally in the Dollar on the announcement of his generous fiscal stimulus plans.
The Dollar grew so strong it threatened to undermine his “Buy American, hire American,” mantra, as imports became even cheaper whilst US exporters suffered.
Redeker thinks his decision to relax banking regulation is actually an anti-Dollar policy as much as a sop to the banking industry.
He sees this as having a negative impact on the currency in the short-to-medium term:
“Imposing a reflationary, economic growth-supporting strategy often runs the risk of it being ‘eaten away’ by early FX moves. The US has faced this risk too, but its government has reacted in textbook-like fashion when dealing with this risk. Instead of relying just on verbal intervention, which in the long term tends to fail if not backed up by concrete currency-weakening policy shifts, or hoping the Fed would impose a super dovish long-term strategy, the US government has pushed for banking sector deregulation."
The Morgan Stanley strategist believes that de-regulation will increase purchases of foreign securities by US banks and this will lead to increased Dollar supply on global markets which should theoretically weaken the currency.
“In the US, it is banking sector deregulation which is allowing banks to deploy capital into higher yielding assets, pushing the return on bank assets and equity yield higher,” says Redeker.
These “higher yielding assets” are often much riskier emerging market assets so the purchasing of them requires an exchange of currency, and the selling of the Dollar.
Improvement in Global Market Fundamentals
The improving economic fundamentals in many emerging market countries is further likely to support a high-risk, foreign asset allocation strategy amongst US investors.
“In the US, it is banking sector deregulation which is allowing banks to deploy capital into higher yielding assets, pushing the return on bank assets and equity yield higher,” said Redeker.
A potential disincentive for investors seeking to invest in riskier EM assets are rising real yields in the US - and indeed many other developed economies (DM) such as the Eurozone and the UK.
The ‘real’ yield of an asset – as opposed to the quoted or nominal yield - is the yield minus erosion from inflation.
Longer-term real yields have been on the rise in DM’s and this would normally be seen as a disincentive to invest overseas, since it would be expected to provide a headwind to emerging market companies, many of whom rely on western or US funding.
“Unlike in 2015, when DM real yields increased leading EM stocks lower, the current rise of DM real funding costs has not caused a similar reaction. EM shares continue to move higher with low valuation and increasing corporate revenues compensating for higher DM real yield,” notes Redeker.
The lack of upside in short-term borrowing rates and real yields, however, relieves the pressure on EM companies, and supports cross border funding.
“Important too is that 2-year real yields have declined, keeping the DM funding gate wide and open,” concludes Redeker.