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The US Dollar is Back in Command: Two Reasons Why

US Dollar exchange rates

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- US  ISM manufacturing index hits 14-year high

- Concerns about emerging market risks and the China-US trade war escalating increased EM outflows on Tuesday

- The US Dollar benefited from corresponding inflows into safe-haven assets

- Expectations for further US economic outperformance stoking gains

The US Dollar is finding a bid for the fourth successive day on a combination of standout economic data and emerging market jitters. 

The ISM manufacturing index rose to a 14-year high in August, reaching 61.3, markets had forecast a reading of 57.6.

"There was no summer vacation at the nation’s manufacturing facilities in August," says Sarah House, Senior Economist at Wells Fargo. "Manufacturing is doing more than simply “holding up” in the face of an uncertain trade environment."

The data will feed into expectations for higher interest rates being delivered by the US Federal Reserve over coming months.

Higher interest rates in the US would be expected to lead to a stronger currency by attracting greater inflows of foreign capital drawn by the promise of higher returns.

Dollar strength is "seemingly the only game in town amid strong US data & heightened risk aversion," says Viraj Patel, analyst with ING Bank N.V.

Of course the risk to the Dollar is that sentiment starts turning lower as US data starts cooling from boiling-hot levels.

"These euphoric readings are not typically sustainable, especially in a strong-dollar environment, and a case could be made that the regional Fed survey, while still high, are beginning to roll over," says House.

ING's Patel agrees. 

Patel believes that there are 'two Dollars' emerging - a Dollar against the Emerging Market currencies and a Dollar against the developed market currencies.

The latter is at risk of giving back some ground.

"We do believe the relative cyclical forces will start to work against the dollar: relative economic momentum (despite the stonkingly high manufacturing ISM), relative monetary policy expectations and relative political uncertainty will start to exhibit similar dynamics that broadly weighed on the USD in 2H17," says the analyst.

 

Strength Against Emerging Market Assets can Roll on

Yet, the Dollar has more than one positive driver at present.

It appears that another prime driver of Greenback demand is a risk-off atmosphere concerning growing Emerging Market (EM) stresses. 

"Renewed stress in Argentina and Turkey have infected EM assets. Weak and disappointing growth data in South Africa also adds to the perception of EM risks. The EM rout doesn't seem to show any sign of loosening its grip for now," says a note from TD Securities.

Investor worries over risks in emerging markets have been deepening on the back of  Argentina’s fiscal woes, Turkey’s currency crisis and balooning deficits, Brazil’s contentious elections and South Africa’s land-reform bill.

South African GDP data earlier showed the country falling into a technical recession for the first time since the great financial crisis, on Tuesday morning,  further worsened the EM rout, and led to USD/ZAR spiking from 14.87 to 15.26 in only 4 hours. 

"For the USD against EM FX, we feel it’s still too early to call a top given the risks associated with US trade and foreign policy over the coming weeks," says ING's Patel.

The atmosphere is ripe for Dollar gains; the Dollar index had risen 0.45% to 95.50 at 12.00 B.S.T; GBP/USD had fallen -0.39% to 1.2824, EUR/USD -0.52% to 1.1561 and USD/JPY was 0.32% higher to 111.43.

Dollar index

The global trade dispute being stoked by US President Donald Trump is another factor aiding the bid for Dollars.

US President Donald Trump has threatened to ramp up a trade dispute with China, with an announcement of tariffs on as much as $200 billion in additional Chinese products as soon as Thursday.

"The Dollar is winning by default," says Kit Juckes, a global strategist at Societe Generale. "There’s not much to make me think the Dollar should be going up, but there’s plenty to make me nervous about other currencies.”

 

Feedback Loop

Concerning the outlook, there is a compelling, albeit simple, reason to suggest the Dollar might continue to gain.

The stronger Dollar creates problems for many EM economies which have high levels of Dollar-denominated debt, as it increases the cost of debt repayments.

This causes a negative feedback loop which is positive for the Dollar but not for EM currencies, with the Dollar rising on EM outflows then causing EM debt repayments to rise, which then leads to increased outflows and an even stronger Dollar.

The feedback phenomenon is an example of 'reflexivity' a term coined by billionaire investor George Soros's to describe the guiding principle underpinning his investment strategy, and the reason why financial markets reach extremes more frequently than statistically expected.

Recently released, broadly poorer-than-forecast global Manufacturing PMI surveys, for August, which showed lower levels of activity in many key EM economies, weighed on the global growth outlook, further supporting the cross-flows out of EM and into the US.

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