The Greenback’s bull run may not be over… yet

Year-to-date, the US Dollar has weakened against many currencies, including the Japanese Yen, the Swiss Franc and commodity currencies like the Canadian, Australian and New Zealand Dollars. This weakness has led to some commentators saying that the USD’s rise since 2014 is now over. However, there exists a high probability that the greenback may roar back to life from here to the end of 2016.

Since the abolishment of the Bretton Woods system back in the early 1970s, the greenback has moved in trends and cycles against the currencies of America’s trading partners. For whatever reasons, these cycles tend to move in tandem with financial market cycles as well as business cycles, affecting investment behaviour and corporate profits, in turn affecting stock prices as well.

The chart below shows the trade weighted index of the US Dollar since 1973 till present, plotted alongside major financial market events over the years.

dxy

Observing closely, the US Dollar tends to have its own ‘bull’ and ‘bear’ markets, with the ‘bull cycle’ lasting roughly 4 -5 years while the ‘bear cycle’ lasting an average of between 8 – 9 years. These cycles are marked with green and red arrows in the chart below:

dxy cycle

Based on what we see above, we are probably still in a bull cycle in the US Dollar (perhaps in the later stages). The greenback’s weakening for the past 6 months has enabled a rally in emerging market assets (debt and equity markets) as well as global commodity prices.

However, the greenback may rebound in this quarter and the fourth quarter as well, and this is based on 3 reasons:

(I) Economic data in the US may come in above expectations

A brief look across various data sets like the US housing market, labour market as well as various leading indicators point to a still robust domestic economy in the US, and improving retail sales data in the past few months may actually lead to stronger-than-expected 2Q GDP growth.

This also puts pressure on the Fed and its guidance for normalising interest rates. While the market believes that the Fed will not rock the boat until the Presidential election in November (and hence assigning an approximate 50% probability of a 25 bps hike in December), expectations could shift as domestic data and inflationary pressures change the dynamics of the investment landscape. Whether or not the Fed chooses to make its move, the US Dollar could reprice gradually upwards should this occur.

(II) Further monetary easing from major developed markets  

Although the ‘policy divergence’ theme has been talked about since 2014, it is still in play in the second half of 2016, with policy-makers from major developed markets (the UK, Europe and Japan) still expecting to increase monetary easing to stimulate their sluggish economies. In fact, policy-makers there may double down on stimulus packages (ahem Japan).

(III) Yield-seeking behaviour 

Following point II, the global demand for high quality positive-yielding assets could actually lead to higher demand for US dollars, leading to a strengthening of the US Dollar vis-à-vis other currencies given that USD-denominated income assets (Treasuries, corporate bonds, REITs, dividend stocks) still offer relatively attractive yields across the G7 space – we see this playing out in Australian and Canadian income-yielding assets so far.

In terms of market positioning, most market participants have actually turned less bullish on the US Dollar year-to-date, as reflected in declining long positions according to futures data compiled by the CFTC (see chart below). This actually sets the stage right for a nice rally from where we are today.

cftc dxy

Implications & courses of actions:

A surging greenback acts as a deflationary force across financial markets, suppressing asset values in emerging markets and typically leading to a tightening of financial conditions across the world. This is because the US Dollar is a global reserve currency as well as a widely-used funding currency, with many corporations across the world using the greenback for financing purposes.

  • mild disinflationary pressures may return to the US if the US Dollar marches higher, putting a cap on demand-pull inflation
  • avoid US companies that rely heavily on exports to Europe and Japan for their revenues as profits could be affected due to losses in currency translation
  • commodity prices may still be under pressure given that they are priced in US Dollars (avoid commodities in the mid-term, bearish bias on the Aussie, Kiwi and Loonie given weak commodity prices as well as declining interest rate differentials, bearish bias on Asian currencies like the CNH, KRW & SGD given sluggish economic fundamentals)
  • avoid equities of emerging markets that rely heavily on USD borrowing and financing (Turkey, Indonesia, etc.)

*I would be targeting to be tactically long the USD against 4 groups of currencies, the first being the currencies of developed markets that are expected to ease further (the GBP & EUR), the commodity currencies (AUD, NZD, CAD, NOK), the Asian basket like the SGD & perhaps the CNH, and those with positive carry like the JPY & SEK; should technicals/price action look favourable*


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