Real yields on US 10-year bonds have risen by 30 basis points since the better-than-expected US employment report on May 3, helping to pull the dollar higher as expectations build that the Federal Reserve will taper the pace of its quantitative easing (QE) programme in the second half of the year.
Indeed, the dollar has broken through some important technical levels this month, last week breaking up through ¥100 against the yen and through parity against the Australian dollar. Strong gains have also been seen against the euro, sterling and Swiss franc.
| Dollar downtrend still intact |
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There are caveats to the sharp gains seen in the dollar in recent weeks. The market might be too aggressive in pricing in a scaling back of the Fed’s QE programme, with weaker US economic data a potential trigger for a reversal in the dollar’s fortunes.
Jens Nordvig, global head of FX strategy at Nomura, says this creates a conundrum for investors, with the tension between the long-run and short-run considerations for the outlook for the dollar creating a trading dilemma.
“The long-run story is clearly bullish, in our view, but the short-run story is much more mixed given the potential for still-soft US data in the next few months,” says Nordvig. “But there is a danger in being too short-term focused.”
Nordvig points out that the recent dramatic turnaround in the yen has proven the importance of momentum when a multi-year currency cycle turns.
“A similar dynamic could be in store for the dollar,” he says. “In the scheme of things, the dollar’s real effective exchange rate is still trading close to multi-decade lows. Once the turn is evident, we believe momentum could be powerful.”
Nomura recommends putting on structural positions looking for meaningful dollar gains by the end of the year. So as to be resilient to dollar weakness in the short term, the bank recommends long-dated call spreads in USDCAD and long-dated put spreads in EURUSD.
Others are more sanguine about the prospects of the dollar escaping the broad downtrend in which it has been trading since 2002.
Indeed, even given the near 1.5% rally in the trade-weighted dollar index since last week, it is still barely higher than it was a month ago and remains range-bound.
| Dollar strengthened but still within range |
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Aditya Bagaria, strategist at Credit Suisse, believes while a broad-based rally in the dollar is likely at some stage, the inflection point is likely to be some way off.
He points out even though sentiment towards the dollar is much more positive than many of its G7 peers, history suggests that rather than rising, the dollar generally falls during the initial phase of a Fed tightening cycle.
| Dollar normally falls within first year of Fed tightening cycle |
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History is not always a perfect guide, but another factor weighing against an imminent surge in the trade-weighted dollar is the composition of the index.
The renminbi has a weighting of 20.3% in the Federal Reserve’s trade-weighted dollar index, the euro 16.5%, the Canadian dollar 12.9% and the Mexican peso 11.3%.
Leaving aside the prospects for the euro, the likelihood is that China will continue to allow the renminbi to gradually appreciate in the coming months, while sentiment towards the Mexican peso remains positive and most predict the Canadian dollar will be well supported.
Meanwhile, the yen and the Australian dollar, the two currencies which have borne the brunt of the recent rise in the dollar, have weightings of just 7.3% and 1.4% respectively in the index.
That suggests a substantial sell-off in EURUSD will be required if the trade-weighted dollar index were to turn higher. However, even then the fact that China, the US’s biggest trading partner, in effect has a fixed exchange rate means it will struggle to gain traction in the coming months.
Apart from the technical factors surrounding the composition of the trade-weighted dollar index, Bagaria believes, from a balance of payments perspective, long-term fundamentals still do not yet suggest the recent rise in the dollar will turn into an extended rally.
He notes that with the balances on foreign direct investment (FDI) and on private portfolio flows still in negative territory, the US still relies on reserve manager demand for US Treasury securities to fund its large current-account deficit.
The most recent broad-based dollar rally began at the end of the 1990s and peaked in 2002. Then, the balance of payments situation was supportive of dollar strength, as the combination of FDI and private – not reserve manager – portfolio flows was enough to fund the current-account balance.
“The persistent funding gap we see today, and will likely see for the foreseeable future, will represent a long-term headwind for the dollar,” says Bagaria.
| Flow picture more supportive of dollar strength in early 2000s |
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In the short term, the dollar might still have room to rally against the likes of the yen and the Australian dollar, but the broader picture suggests it is too early to declare the end of its 11-year downtrend.