Beleaguered dollar bulls have cause for hope after absorbing the most punishing six months in a decade.
With a little help from President Donald Trump and Federal Reserve Chair Janet Yellen, the tide may be turning for the world’s reserve currency. It’s risen from the lowest in more than two years, spurred by the Republican leadership’s announcement of a long-awaited tax plan and the central bank’s signals that it’s looking past tame inflation and expects further tightening.
The rebound could be a sign of things to come in a quarter that’s seen dollar gains for six straight years. But the currency has more than history on its side. The market has priced in little for the Fed beyond December and even less for progress on a tax overhaul, said Alan Ruskin at Deutsche Bank. That leaves the greenback primed for a bounce, potentially catching off guard speculators who are the most bearish since 2013.
“We’re now in an environment where the market is flirting with the idea of fiscal stimulus and tighter monetary policy, happening in the context of the Fed, which is likely to move in December,” said Ruskin, global co-head of foreign-exchange research. “There’s plenty pointing towards a squeeze in short dollar positioning.”
Explanations vary for the fourth-quarter resilience, with the Bloomberg dollar index gaining almost 3% on average in the period since 2011. Year-end repatriation and the lure of US equities, which also tend to rally in the same stretch, may be at work, said Shaun Osborne at Bank of Nova Scotia. George Saravelos at Deutsche Bank points to a pattern of seasonally stronger economic data. There’s evidence for that in Citigroup’s US economic surprise index, which often sees improvement in the second half of the year.
But some of the world’s biggest investors are starting to buy dollars based on more than seasonal patterns. It’s a bold bet that faces plenty of obstacles, from the uncertainty surrounding Trump’s choice for Fed chair to the long road ahead for the debate over tax reform.
The greenback’s revival in the past month coincided with a surge in December Fed hike odds, as Yellen said it would be “imprudent” to keep monetary policy on hold until inflation reaches the Fed’s goal.
The market-implied probability of a third hike in 2017 is above 60%, from around 20% on September 8, though an increase isn’t fully priced in until next year. Traders aren’t completely on board with tightening beyond that until 2019. Meanwhile, policy makers see scope for three additional hikes next year and more to follow.
For Deutsche Bank, the gap between market expectations for the terminal rate and the Fed’s view is ripe for an adjustment that may drive dollar gains. A measure of where traders see one- year rates in three years has peaked at around 2.25% since mid-2015, and now sits at about 1.9%. That leaves room for it to climb, with the help of a catalyst such as increased clarity on tax policy, the bank predicts.
“If you can get the market not only thinking about the next rate hike, but multiple rate hikes, that’s a more dollar-friendly environment,” Ruskin said.
Revived optimism for fiscal stimulus could singe dollar bears, who’ve profited from the currency’s 8% slump in 2017 as the so-called Trump Trade faltered.
The GOP’s latest tax framework includes lower levies and a one-time tax on US companies’ estimated $2.6tn of accumulated offshore earnings that would clear the way for repatriating that income. To be sure, Congress’s track record this year in attempting to repeal Obamacare and the tax blueprint’s potential to widen the deficit have damped enthusiasm for action on that front.
Passing any sort of tax bill would be a boon for the greenback, said Ugo Lancioni, a money manager in London at Neuberger Berman Group, which oversees $271bn.
“If they deliver something, even if it’s not much, it’s going to be dollar-positive simply because the market hasn’t priced the possibility that they will have some success in boosting growth, especially on the tax front,” said Lancioni, who’s been long the dollar since August.
And then there’s market positioning to consider. Even after the dollar halted its six-month slide in September, hedge funds and other large speculators are the most bearish since 2013, Commodity Futures Trading Commission data show.
That leaves traders leaning the wrong way if the dollar’s recovery gains steam, a scenario that looks more likely with Catalonia on the verge of declaring independence. The move could heighten euro-area political tensions and darken the outlook for the shared currency.
After reaching $1.2092 in September, the weakest in more than two years, the dollar has recovered to about $1.1750 per euro. A meaningful breach of $1.17 would accelerate the greenback’s gains, according to Osborne, Scotia’s chief currency strategist.
“Weakness below that point is going to add negative momentum to the euro and probably force out some of the recently minted long euro positions,” he said.
Friday’s US employment report poses a near-term test for the dollar. Job creation probably took a hit in September in the aftermath of the deadly hurricanes. In the months ahead, the labour market may recover, leaving investors to focus on the two main pillars of the bullish dollar case for the year’s final months.
“A small fiscal stimulus would still be extremely positive for the dollar,” Ruskin said. “We’re at full employment already and the Fed will have to respond with tightening monetary policy in 2018. It’s kind of a perfect combo which would be significant for the dollar.”
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