Is the dollar in the midst of a “great correction”? Or is this the new normal?
Increasingly, market strategists and investors seem to be betting on the latter, driven by the notion that the world’s largest central banks have given up on trying to influence exchange rates with monetary policy, for a number of reasons.
Meanwhile, the recent uptick in U.S. inflation is eating into what’s called the real interest-rate differential — the difference between returns on U.S. dollar-denominated assets and those priced in foreign currencies when adjusted for inflation. This lowers the return on dollar-denominated assets relative to those denominated in other currencies, making the buck less attractive to investors. Many other developed economies like the eurozone and Japan have struggled with too-low inflation for years.
And traders have taken notice. Data reported Friday by the Commodity Futures Trading Commission show that the aggregate total of bets that the dollar will strengthen has fallen to its lowest level since July 2014 (See chart below).
“We’re coming out of a massive dollar overvaluation,” said Vasileios Gkionakis, head of global currency strategy at UniCredit Bank. “Central banks are stepping back a bit from their currency obsession.”
A chart shared by Société Générale (included below) currency strategist Kit Juckes shows how a widening inflation gap between the U.S. and Europe—expressed by calculating the difference between 2-year swap rates minus headline consumer-price index—suggests the dollar has further to fall.
In comments made last week, Federal Reserve Chairwoman Janet Yellen explained her outlook for the dollar, emphasizing that the central bank would take a cautious approach to raising interest rates. Yellen, and other Fed officials including Chicago Fed President Charles Evans, have cited the risks of raising interest rates before rising inflation has been firmly established.
Getting out of hand
In the beginning, the dollar rally was fueled by the expectation that rising interest rates would drag U.S. real yields higher as other large central banks experimented with negative interest rates—broadening the differential from both ends, Gkionakis said.
But these expectations quickly got out of hand, Gkionakis said. In the first half of 2015, the euro-dollar EURUSD, -0.0791% pair bottomed out below $1.05—much lower than expectations for policy divergence could possibly justify.
Now, investors are re-evaluating their outlook for the greenback. Gkionakis expects the dollar to drift lower over the next few years, even as U.S. interest rates rise, because the buck has already priced in normalization in monetary policy, more so than what Treasury yields have reflected.
“Even when divergence manifests itself, it does not mean that it will be beneficial for the currency, because the currency has already priced all that in,” Gkionakis said.
The dollar’s weakness is happening against the backdrop of a fundamental shift in how central banks are conducting monetary policy—and that is no coincidence. At the European Central Bank meeting in March, the euro jumped higher after President Mario Draghi said he didn’t anticipate any further interest-rate cuts—a sign that the central bank is no longer directing monetary policy with the primary aim of weakening its currency.
This change of heart was driven largely by the fact that central bankers have realized that maintaining negative interest rates and other ultraloose monetary policies can have diminishing effects, Gkionakis said.
The are also many potential risks.
Legendary bond investor Bill Gross has warned, negative rates put undue pressure on the financial system while not accomplishing important policy goals like pushing investors into riskier assets.
The dollar will rise again
Gkionakis noted that there is one major risk to his outlook. The possibility of a much stronger than expected rebound in U.S. growth. The gains would need to be strong enough to convince investors to price in a faster pace of interest-rate hikes.
To be sure, there are still a number of currency strategists who are standing by their view that the dollar will begin strengthening by the end of the year—though most acknowledge that the potential for short-term weakness is high.
In a note released Monday, a team of global strategists from Bank of America said they continue to see the euro finishing the year at parity with the dollar.
While the recent pickup in inflation and inflation expectations will likely continue to weigh on the dollar in the near term, in Bank of America’s view, the theme of policy divergence will eventually re-emerge, driven by U.S. growth outperformance.
Once that happens, they say, traders will come rushing back to the dollar, sending the euro tumbling to parity with its U.S. rival for the first time since late 2002. The dollar’s run, as measured by the ICE Dollar Index DXY, +0.04% has seen it gain around 17% since July 2014.
So far, however, few strategists and traders have been successful in making bets on the dollar’s reaction to central bank policy.
Post a Comment