I need a dollar
US$ strength to come?
Going into 2017, the market consensus was one of a strong US dollar environment, with the expectation of the US engine firing on all cylinders, with support from fiscal policy, monetary policy and de-regulation. The engine has stuttered, the US dollar has been declining all year and not many US dollar bulls are left. We are taking stock.
With the election of US President Trump, expectations were high for major tax reform (with speculation on the introduction of a border adjustment tax and a new homeland investment act), increased infrastructure spending and cutting of red tape. The Fed would hike rates as more stimulus against a backdrop of a tight labour market only pushes the economy faster to late cycle. And last but not least, US dollar strength would be compounded by Chinese yuan weakness amid pressure on the Chinese capital account.
Most of it hasn't materialised (yet). Tax reform is only scheduled for after the healthcare bill, with the latter proving to be a hard nut to crack for US Congress. More spending on infrastructure is easier said than done, as the money needs to come from somewhere. Changing regulation also requires US Congress, but despite a Republican majority, it isn't running like an oiled machine. Lastly, while the Fed has hiked twice this year, expectations of relative monetary policy between major central banks is converging. The below chart shows market expectations of where relative short-term rates (3-month time deposits in US dollars versus euros) are at the end of 2019. Those expectations have peaked around year-end and have come down ever since.
With expectations elevated and US dollar positioning long at the start of the year, the bar to surprise markets was high. We reduced our US dollar positioning in our portfolios accordingly, but have kept a long bias, as we see a strengthening US dollar in most of our pertinent risk scenarios. China remains our big worry in the medium term, and with it renewed pressure on the capital account and the renminbi, despite successful (capital control) efforts in the short term to stabilise China's foreign exchange reserves.
So, what's our view on the US dollar today? For ease of discussion we look at the US dollar versus the euro, but the conclusion holds more broadly. We are not throwing in the towel on the US dollar.
The US economy is further along in the cycle than Europe, but has recently enjoyed a loosening of financial conditions (amid a weaker currency, lower yields and credit spreads, and higher equity markets). Inflation has surprised to the downside, but together with the Fed we believe this is only a temporary phenomenon given limited economic slack. We see the Fed continuing to hike rates gradually, while the ECB will only start hiking rates after tapering has finished and not before inflation is moving back to target, which we do not see happening within the next couple of years.
US fiscal policy and de-regulation expectations are now sufficiently low that we see the risks actually to the upside. Structural problems in Europe have been less prominent than we feared (amid decent cyclical growth and fading political risk), but optimism seems priced in as well. All in all we see policy and political risks, giving expectations, favouring the US dollar over the euro.
US dollar positioning has swung from a sizeable long at the start of the year to a short now. The chart below shows investors were willing to pay more for hedging with options against US dollar strength than weakness. Today this has completely reversed. Again, this is true against the euro, but can be extended more broadly.
With lower expectations for some of the potential positive US dollar drivers, but economic and political optimism on Europe, we think the risks for the US dollar are to the upside versus the euro and more broadly.
Finally we believe a long dollar position helps us in balancing out our risks in the portfolios. In many risk scenarios we construct the US dollar plays an important role, as we see US dollar strength in many of those scenarios. For instance in a China crisis, probably our most prominent medium-term risk, we would expect the dollar to appreciate significantly against Asian currencies.
On a less serious note, if you need more convincing just listen to the song "I need a dollar" by Aloe Blacc.