Market pricing was extremely short USD against 6 major currencies.
Since hitting a 14-year-high back in January the dollar has traded on the back foot. Most of its depreciation has been against DM currencies, primarily the EUR which has gained 14% so far this year. Because of geopolitical risks the dollar looks set to decline in August for the sixth consecutive month. But we think there are at least six reasons why the risk for the dollar is skewed to the upside heading into Q4.
1 Policy rate expectations. Market expectations for policy rate hikes over the next two years discount more increases from Canada and Australia than from the US. But we think the probability of a 25bp Fed rate rise in December is 80%, not less than 25% as the market currently discounts. That would leave traders anticipating less than one more hike in the subsequent 15 months, which we judge to be far too dovish considering inflation is effectively on target and the market is forecasting GDP growth above 2%.
2 FX valuation. Thanks to prior Fed policy tightening the dollar has been rich for the last few years; thanks to ECB policy easing the euro has been cheap. This is changing. Valuation can provide only a moderate headwind or tailwind at the best of times, but now the tailwind for the euro is fast turning into a headwind. On a different valuation assessment – the IMF’s FEER methodology – the euro is now 3.5% above fair value. Euro appreciation (and therefore dollar index depreciation) is no longer a foregone conclusion.
3 Balance of payments dynamics. As the euro strengthens so the euro area’s current account surplus declines. By contrast, the US’s balance of payments is driven by fundamental change and is less sensitive to currency strength. After running an energy trade deficit for most of this century, the US has an energy trade balance close to zero. Despite the dollar’s strength in the last few years net exports have halved from -6% of GDP in 2005 to -3% of GDP now. The US will continue to exploit its strong energy export position while a more traditional currency/trade dynamic is likely to stay the euro’s hand, once again supporting the dollar.
4 Data divergence. In our view global growth is pulled along by three locomotives – the US, China and Germany. The lead changes amongst the three. In the last few months Germany has been ahead, as strong survey data and last week’s GDP report confirmed. But market pricing compares outcomes to expectations. In that regard the US has begun picking up again. Economic data have, on average, beaten expectations in the last couple of months after a soft patch in H1. Meanwhile the Li Keqiang (LKQ) indicator for China peaked in February and suggests a pause in growth, in line with our post-Congress view. This divergence should lead to a repricing of monpol expectations and support for the dollar.
5 FX positioning. Total short-dollar CFTC IMM positioning is close to a record high. Although stretched positioning is not necessarily a sufficient condition for a reversal, it is a necessary one. Investors are particularly short dollars against the euro, the Swiss franc, Mexican peso, New Zealand dollar and Canadian dollar.
6 Seasonality. Seasonal strength in Q4 has seen the dollar rally by 2% on average over the last 10 years. Although the hit rate is only 50% (in half the years it has fallen into year-end), the skew is positive with rallies twice as big as sell-offs. The balance of risk on seasonality is towards a dollar rally.
DXY index rises from 92.81 at time of publication to peak at 94.39 on 29 October. We also expressed this view through a USD/CAD call spread.