- Ex-US growth has been strong, and continues to strengthen
- Fed rate hikes causing speed bumps, but expectations for tighter monetary policy are rising around the world
- Shorting the dollar is not yet a global consensus trade
The US dollar currency index, a measure of USD against six major peers, declined by 9.9% in 2017. Last month, the currency index continued declining and fell by another 3.3%. Given the speed of the recent decline, the US dollar started looking oversold according to technical indicators around mid-January. While we warned that the currency was looking oversold in several recent editions of our US dollar daily update, the underlying drivers behind the ongoing bear market remain intact. In our view, any strength is likely to be a short-term correction while the longer-term trend remains bearish. Here are three reasons the bear market is more likely to continue.
Global growth continues to accelerate
As can be seen from GDP growth figures below, growth in the world’s largest economic regions has been on an accelerating trend since mid-2016. Even Japan, which has historically underperformed developed countries, has managed to generate year-over-year growth in excess of 2%.
Faster and faster: largest developed markets deliver solid growth
Looking at the chart above, GDP growth in the world’s largest economic regions looks healthy. As we have explained in the past, the US dollar tends to weaken when ex-US growth is accelerating given the dollar’s function as the world’s reserve currency. Thanks to deep US capital markets and the relative ease of borrowing dollars offshore, US dollar credit taps flow freely during a global upswing. As more and more dollars chase international investment opportunities, the currency weakens in response. During global downturns, the opposite happens as the dollar tends to strengthen. This is because foreign borrowers struggle to repay US dollar loans, and begin dumping other assets in exchange for US dollars. Similar to other world reserve currencies, the dollar thus exhibits the characteristics of a safe haven asset.
Forward-looking indicators, such as manufacturing PMIs, also point to continued growth outside the United States. As the world’s leading industrial exporters, expansion in Eurozone and Japanese manufacturing bodes well for future global growth. As PMIs in both regions have accelerated above 55, the future outlook for growth is positive.
PMIs in the Eurozone and Japan also point to accelerating growth
As long as global growth continues to accelerate, the US dollar should remain weak.
Upcoming rate hikes to cause speed bumps, but unlikely to derail the trend
In early 2017, many commentators believed the dollar was likely to keep strengthening as the Federal Reserve was one of the few central banks committed to raising rates. At the time, Japanese growth was underperforming while many believed the Eurozone was on the verge of breaking up. Few could foresee the upturn in the global economy, and the corresponding sell-off in the US dollar in 2017.
Today, many continue to believe that the US dollar will strengthen thanks to its relative yield advantage. While US interest rates are meaningfully higher relative to the Eurozone and Japanese rates, what matters more is the future outlook. Looking at the Eurozone and Japan, expectations are rising for its respective central banks to begin monetary tightening later this year.
As the Eurozone is now growing at its fastest pace in many years, expectations for tighter monetary policy are rising. Today, the European Central Bank is running out of excuses to continue its asset buying program despite weak inflation. While several ECB officials have publicly commented on inflation (worsened by a rising euro), quantitative easing was intended as a short-term emergency response to the Eurozone debt crisis. Thanks to the improving fortunes of the region, emergency measures are no longer necessary, and this is why traders continue to pile into the common currency.
Similar themes have helped the yen lately. Unlike the ECB, the Bank of Japan is not expected to end its asset buying program. However, expectations are rising for the Bank to reduce the scope of the program. More specifically, many believe the BoJ will attempt to engineer a steeper yield curve in order to improve the performance of Japanese banks. In a recent commentary on Japanese monetary policy, we argue that changes to the yield curve are more likely to occur later this year. Recent strength in the yen is likely to be premature.
US dollar sentiment not looking stretched
Lastly, speculators are not (yet) at a bearish extreme based on net short positions. Looking at futures and options data from the Commitments of Traders report, only a small proportion of the total outstanding interest is currently short the dollar. While the prevailing view is that “everyone is short the dollar”, this is not borne out by the data. Implied USD positioning (the inverse of net positions in EUR, JPY, GBP, CAD, AUD and CHF) is illustrated below:
US dollar speculators not (yet) at a bearish extreme
While speculators are net short the dollar to the tune of almost 100,000 futures and options contracts, this represents only 5.3% of the total outstanding interest in the currency. Historically, the dollar has sold off after net positions as a proportion of open interest is at least 15%. This can be seen in the graph above: when bullish positioning in January and March 2017 became excessive, the dollar began selling off. This means the dollar can keep weakening without running into too much resistance for now.
No help from economic data, monetary policy and sentiment
All in all, the US dollar is receiving little assistance from economic data, monetary policy or speculator sentiment. Ex-US growth remains on a strengthening path, while shorting the dollar is not yet a global consensus trade. Finally, expectations for monetary tightening in both the Eurozone and Japan means that the Fed’s rate hikes won’t necessarily strengthen the currency against its most significant global peers.