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Fixed-Income Insights

The U.S. dollar has fallen, despite some events that, on the surface, should have caused the currency to rise in value.

The peaks and valleys of the U.S. dollar (as measured by the Bloomberg Dollar Spot Index, or BBDXY) since the U.S. presidential election in November 2016 have many investors wondering what exactly is going on. Immediately after the election, the dollar fell against the BBDXY’s basket of 10 currencies, only to rise sharply pretty much for the balance of the year, until January 2017, when it began a decline. At its low point for the year so far, on May 17, the BBDXY had fallen 5.76% since January 3—this, despite some events that on the surface should have caused the dollar to rise.    

For example, the U.S. Federal Reserve (Fed) rate hike on March 15 happened earlier than had been expected at the beginning of the year. In addition, some economic data, mainly surveys and confidence indexes, have been coming in better than expected, although the “hard” data have yet to follow through.  Moreover, geopolitical risk has risen along with increased military responses in Syria, Afghanistan, and perhaps to come in North Korea. Typically, this would be positive for the dollar as the “safe haven” currency.

 

Chart 1. The Dollar’s Weakness of Late Has Defied Expectations
Bloomberg Dollar Spot Index; Daily, May 17, 2016–May 17, 2017 

Source: Bloomberg.

 

So, why has the dollar been weaker? There are several possible explanations that we think are working together. 

First, on the economy, the market has had to revise down its expectations for how quickly the real economic data will pick up. Citigroup’s Economic Surprise U.S. Dollar Index “peaked” on March 15, and since has moved sharply lower. The U.S. dollar index measures the expectations of economists with regard to the currency against the actual movement of the dollar in foreign exchange markets. When data are coming in weaker than expected, the index declines. As this is a mean-reverting series, the pullback should not be surprising, but it is noteworthy nonetheless.  

 

Chart 2. The Market Has Revised Downward Its Expectations for Economic Recovery
Citi Economic Surprise Index – United States; Daily, May 17, 2016–May 17, 2017 

Source: Bloomberg.

 

Inflation, in particular, has not shown signs of a meaningful pickup outside of commodity prices, which leads to a second point on the Fed. Even when the market started pricing in an earlier hike, it did not increase the overall rate path. The Fed itself kept its “dot plot,” showing the expected number of hikes each year, the same in March as in December. And the focus of recent speeches from members of the Federal Open Market Committee (the Fed’s policy-setting arm) has been on how and when the Fed may begin reducing its balance sheet. The market is interpreting balance sheet reduction as a substitute for additional rate hikes. The links among balance-sheet reduction, longer-term rates, and the dollar are not as straightforward as the link is between the dollar and hikes in short-term rates.

Third, the United States now has the third highest interest rate in the developed markets. That means the dollar has been trading like a higher-carry currency within the major currencies. Carry is usually associated with “risk on.” So when risk sentiment is strong, the winning strategy is to buy the high yielders and sell the low yielders. When risk sells off, this switches, and the high yielders tend to depreciate much more than the low yielders. The 10-year Treasury yield has declined 40 basis points from its peak on March 13—a drop that made holding the dollar less attractive on an absolute basis. It also should be noted that the cross-currency basis swaps have returned to more normal levels, meaning that it is less expensive to hedge dollar exposure if you are a European or Japanese investor, especially as compared with the second half of last year.  

Finally, it cannot be ignored that at least some foreign exchange-market participants have been disappointed by the pace of fiscal policy. U.S. tax reform has been pushed back to later this year, at best, and the probability of the so-called border-adjustment tax or any other major trade initiative has certainly decreased (witness the U.S. stepping back from pulling out of NAFTA). The U.S. president has soured on the idea of a strong dollar, finally realizing (as most countries have for decades) that a (modestly) weaker currency has its benefits. While there is not much that any president can do to engineer a weaker dollar directly, this does mean that the administration may shy away from policies that would cause significant dollar appreciation.

Outlook
As of May 17, the U.S. dollar is back to levels just before the election, driven by declines against both developed market and emerging-market currencies. But we think that the dollar will start moving higher again, especially against other major developed currencies, as the U.S. economy picks up strength after a very weak first quarter. We expect the Fed will continue its gradual rate-hiking cycle, and even begin balance-sheet reduction later this year. Treasury yields should head higher, affecting the Japanese yen first and foremost.  

Elsewhere, it may be difficult for Europe to improve upon or even repeat its much improved economic growth numbers. There are definitely signs that Europe may have reached “peaks” in certain confidence indicators and those indicators may be coming down. We are still constructive on emerging-market currencies versus the U.S. dollar, as trade volumes have picked up and commodities seemed to have stabilized. China also should remain stable as the government faces a plenum in November where the premier and the cabinet are reappointed, and Beijing does not want any disruptions before then. 

 

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