USD: The bear market case - AmpGFX

In view of Greg Gibbs, Director of Amplifying Global FX Capital, we appear to have moved into a proper bear market for the USD. 

Key Quotes

“There may be several factors explaining this.

MP no longer diverging

In 2014 and 2015, the USD appeared to be boosted by the notion of diverging monetary policy, where the Fed was the only central bank considering to be raising rates. This is no longer a driving influence; even though there are still few other central banks considering hikes, the broad impression is that other major country central banks are tilting towards less policy accommodation.

QT means lower rates profile

The Fed is moving towards unwinding its balance sheet; let’s call in quantitative tightening (QT). This means it is less likely to raise rates over the period ahead. The Fed has been trying to say QT can happen in the background and may not affect its rates policy. But it is a form of tightening, and naturally, will make the Fed more cautious about future rate hikes.

Some may argue that QT might support the USD, but the links from QT to currency are loose and probably flow through its impact on rates and yields, and in turn other asset classes. It may cause the US yield curve to steepen, but not raise overall yields. And yields may take some time to rise anyway, as QE abroad and low inflation expectations globally hold yields down.

Synchronised growth and dollar smile

The US economic recovery is no longer so special with more synchronised global growth. The OECD reported last week that it has forecast growth in all of its 45 countries for the first time in a decade, and 33 are accelerating, the most since 2010. A popular idea introduced by Stephen Jen about a decade ago, a highly rated currency strategist turned hedge fund manager, is that the USD's performance tends to have a smile when plotted against US economic growth. It does well when the US economy is significantly out-performing the rest of the world, or the US and the world are in distress, but tends to fall when the global economy is in synchronised growth. 

Capital flow and balance of payments

Part of the smile theory relates to capital flows and balance of payments. Capital is flowing more readily to EM markets. Their external positions are improved, whereas the USA still has a significant current account deficit (-2.4% of GDP in Q1). The US equity market is more fully priced and investors are seeking to diversify returns shifting capital towards other capital markets. Emerging markets are now at their strongest position since 2014, and exposure to this broad asset class has no doubt increased significantly. However, emerging markets have more broadly underperformed since the Global Financial Crisis with regular major setbacks; including the Eurozone crisis, the 2013 taper tantrum, oil price shock and China deval in 2014/2016. If investors are seeing EM as in their best relative position since the GFC, the current rally could extend for another year or more.

FX reserves growth

During prolonged past phases of EM market out-performance, the USD has been thought to underperform as EM countries FX reserves grow, and they look to diversify these reserves into other currencies. As FX reserves start to move into a growth phase, analysts may again argue that this tends to make the USD fall more broadly. We are not in a clear growth phase for FX reserves yet, but we are seeing some evidence of this starting. As it stands, FX reserve managers may feel they are under-weight EUR, with around a record low allocation in Q1.

Political uncertainty

The decline in the USD appears to also reflect the heightened political uncertainty in the US. In recent weeks, President Trump has openly criticised Republican leaders in Congress over their failure to date to achieve a rise in the debt ceiling, and he has threatened to demand border wall funding even if this causes a government shutdown. The market is seeing a significant risk of this occurring, raising political risk for the USA to new highs, from an already elevated level related to the administration’s pursuit of an Alt-Right tinged agenda and erratic confrontational leadership style.

EUR hedges unwinding

The EUR is the highest weight in USD indices, and it is leading the gains this year. Investors are widely thought to be unwinding FX hedges on their Eurozone asset holdings this year. Economic growth and political stability have boosted the case for holding Eurozone assets. The valuation assessment of Eurozone assets includes the EUR exchange rate. If Investors are currency hedged, they risk missing out on valuation gains if they come through EUR currency appreciation rather than asset price appreciation. As such unwinding EUR hedges makes sense from a diversification and risk management perspective. During the ECB QE expansion phase, the EUR was considered a weak currency, and it made sense to hedge. There may still be large amounts of these 2014/2015 era hedges to be unwound. The Eurozone has a significant current account surplus (3.5% of GDP in Q1), so without capital outflow, it will tend to appreciate.

It is interesting to note that there has been only a subtle shift in ECB policy and it still has negative interest rates. This might ultimately temper the EUR recovery. But over the longer term, EUR has had a very inconsistent relationship with short term interest rates, and that relationship has been essentially non-existent in the last year. Over a long term perspective, the EUR is near its long run real average. The ECB may not want a rapid recovery, but there is little evidence yet that its rise is curtailing the Eurozone economic recovery of dampening inflation expectations.”