The US dollar, traditionally a safe haven currency during volatile times, has been trading near multi-year lows. However, this may not be the end to the greenback woes. Below are ten reasons why the dollar will continue to see weakness.
Fed tightening priced in
The Federal Reserve’s path to tighter financial conditions is now largely priced-in by the markets. Conversely, the path to policy normalisation faced by the European Central Bank (ECB), Bank of England (BoE) and Bank of Japan (BoJ) has either not started or barely begun. Indeed, both the BoJ and ECB are still deploying QE.
Divergent expansionary paths
The European and Japanese economies are also less advanced in their expansion cycles than the US economy. In this context, and where both Eurozone and Japan have current account surpluses of around 3 per cent of their GDP, economic fundamentals point to a phase of euro (and eventually) yen strengthening against the dollar, which faces the American ‘twin deficits’ - external and budgetary.
Trump tariff effect
US President Donald Trump’s announcement of the introduction of import taxes on steel and aluminium only adds to driving down the greenback. Indeed, this action seems to be implicitly aimed at weakening the dollar and will accelerate the dynamic of respective strengthening of the euro and the yen.
Cost of hedging
The cost of hedging is perhaps a less considered but important factor. Hedging USD risk has increased meaningfully since the last quarter of 2017, which makes investments in US treasuries by European or Japanese investors costly.
Diversification less appealing
European and Japanese investors, amongst others, were directed towards buying US Treasuries due to the negative yields in their domestic government markets, while at the same time adding to portfolio diversification. Currently, as the cost of hedging EUR/USD and JPY/USD is increasing, the above-mentioned financial flows and subsequently the diversification benefit is less interesting. This will continue to become less attractive when Bunds (and one day JGBs) offer positive yields.
Upward pressure on euro
The ECB and BoJ government bond purchases were above net issuance, contrary to the Fed treasury purchases that never exceeded net issuance. This situation forced domestic buyers of government bonds such as insurance and pension funds to increase their exposure to foreign bonds, essentially US treasuries. As a result, normalisation from the ECB could apply upward pressure on European rates and strengthen the currency.
US equities lose appeal
Valuations of the European and Japanese equity markets are less strained than those of the US market and their growth potential appears to be greater given the stages of their economic cycle. This stock market dynamic - and its effect on investor demand for US dollar-priced stocks - creates a further headwind.
Increasing fiscal deficit
This is not the only Trump ‘America First’ rhetoric that is affecting the dollar trajectory. In addition, the US tax reform indicates an increase of fiscal deficits, which historically has tended to weaken the dollar.
Diminishing greenback support
Assuming a continuation of synchronised global growth and the gradual normalisation of monetary policies in Europe and Japan, the financial flows that have supported the dollar in recent years should reverse. With negative 10-year Bund and Japanese Government Bond (JGB) rates, European and Japanese bond investors had been pushed towards US treasury bonds in order to generate returns – we see this dynamic unwinding.
China reduces Treasury exposure
China is not allowing the value of the renminbi to fall, as Beijing worries about being accused of currency manipulation. At the same time, the People’s Bank of China is not buying as many US treasuries as it usually does.
It should be noted that a trend of a weakening currency rarely develops ‘in a straight line’ and that correction phases, after rapid movements spurred by changing macro or central bank policy can stimulate significant rebounds. However, the elements discussed here underpin our expectation of a continued dollar weakening trend.
Michalis Ditsas is fixed income investment specialist and Fabrizio Quirighetti is co-head of multi-asset and manager of the OYSTER Absolute Return fund at SYZ Asset Management.
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