BAML: 3 reasons why the US dollar should continue to rally


While it initially fell in the immediate aftermath of the FOMC September rate decision released late last week, an understandable response given the dovish monetary policy statement, forecasts along with the overall decision to not increase interest rates, the US dollar has found renewed strength in recent days, sitting at levels prior to FOMC decision.

Although unusual, and something that warrants near-term caution, according to Bank of America’s global rates and strategy research team, there are three factors currently at play that suggest “tactical USD longs could make sense”.

Ian Gordon, Adarsh Sinha and Yang Chen, part of the bank’s FX and rates strategy team, believe that reduced US dollar long positioning, robust US economic fundamentals and the growing risk that other major central banks will add to already-accommodative monetary policy conditions all point to the potential for further US dollar strength in the period ahead.

The trio notes that US dollar long positioning has declined in recent weeks, seeing net long positioning fall back to levels last seen before the greenback began its rally midway through last year.

“USD long positioning is now at its lowest level since the dollar rally began. Investors still maintain a net long USD positioning, but the 2Y percentile rank of speculative positioning is at the lowest level since July 2015”, they wrote.

“The pullback, while understandable given the fact the USD has been largely range-bound in recent months, could provide an opportunity with macro fundamentals continuing to support Fed hikes”.

The chart below shows the pullback in speculative US dollar long positioning in recent weeks.

Positioning aside, Gordon, Sinha and Chen are also bullish on the outlook for the US economy, particularly the labour market.

“Despite the Fed’s dovish pass, the pieces remain in place for a continued labor market tightening that will likely underpin rate hikes later this year”, the note, adding “such gains support our view that the unemployment rate will easily breach the Fed’s 4.8% end-2016 forecast, putting further upward pressure on prices and wages”.

They also suggest that Fed inaction in September will also increase the likelihood that other major central banks such as the ECB and BOJ may loosen monetary policy settings further, something they believe the markets are currently underestimating.

“The Fed’s dovish hold increases the chances for overseas easing that we think is not fully appreciated by the market. The Fed’s delay will likely push the ECB to more action, and sooner, with the ECB keen to maintain a wide policy gap with the Fed”.

“We now see October as our base case for an extension of its existing QE program beyond September 2016”, they note.

Not only do they believe the ECB may extend its quantitative easing program next month, they also suggest that there are now risks that the BOJ will also increase the size of its asset purchase program.

“Our base case sees the BOJ on hold in October but an increasing nod to external risks in its most recent statement, combined with slowing GDP growth, inflation & inflation expectations suggest the market could price a greater risk of easing”.

While they believe these three factors could “provide an impetus for the next leg higher in the USD”, they have placed a caveat on their call – the potential for further substantial weakening in the Chinese renminbi.

“Given its likely impact on commodity prices and inflation could make it difficult for the Fed to hike”, they wrote.

Although they believe the US dollar may continue to strengthen in the period ahead, they favour waiting for further clarity on central bank policy action, along with better entry levels, before adding to or initiating long US dollar positions.

Business Insider Emails & Alerts

Site highlights each day to your inbox.

Follow Business Insider Australia on Facebook, Twitter, LinkedIn, and Instagram.