After gaining more than 27% from May 2014, the rally in the US dollar index came to a shuddering halt earlier this year, falling 8% in less than three months.
As the table below reveals, supplied by Deutsche Bank, the correction in the dollar was not only one of the largest seen in recent decades, but also one of the longest.
As a result of the correction, risk assets rallied around the world, boosted by sharply lowered expectations for US rate hikes in the years ahead.
It was a remarkable recovery, coming after an equally sharp and to some, bizarre, correction in the first six weeks of the year.
Of late, those factors that led to the sharp decline earlier this year have reversed, with expectations for a US rate hike this year shooting higher last week following the release of the minutes from the Federal Reserve’s March FOMC meeting which suggested members were far closer to hiking rates than what many in markets were expecting.
US bond yields spiked, as did the US dollar in response, extending its recovery from early May to over 3%. Stocks and commodities, broadly, fell as a consequence.
With markets now of the view that a US rate hike this year is more likely than not, the question many are now asking themselves, particularly given the relationship between movements in the dollar and other asset classes, is whether the rally in the greenback will continue.
To researchers at Deutsche Bank, the recent price action suggests that the lows for this year have already been seen, predicting that the recovery will likely continue in the period ahead.
“The dollar has undergone a painful correction since the start of the year but we don’t believe this marks the end of the dollar uptrend,” says Deutsche.
“At around 8% the size of the dollar’s correction is the third largest in history compared to other dollar uptrends. The calendar length of the correction is approaching a record too. At 100 days it is the second longest in history which together with the size suggests we have likely seen the low in the dollar this year.”
Aside from a statistical perspective, Deutsche suggests the prospect of higher US interest rates, compared to other major currencies, will likely underpin the dollar’s recovery.
“The ranking of US yields versus the rest of the world is an important driver of medium-term dollar cycles, and the dollar does well when it becomes a (top-3) high-yielder in the G10,” it notes.
“Even assuming a 1% Fed terminal rate in this cycle puts the dollar in the ranks of high-yielding status, an environment that has been associated with significant dollar rallies in the past.”
The chart below, provided by Deutsche, reveals the historic performance of the US dollar against G10 currencies based on yield differentials.
When it’s a top-three yielding currency compared to other majors, shown in red, the US dollar tends to outperform.
Outside of major currencies, Deutsche suggests that the dollar offers greater value against emerging market currencies, citing the Federal Reserve’s Other Important Trading Partners (OITP) dollar index, a trade-weighted gauge that only includes its largest emerging market trading partners.
“The real (inflation adjusted) OITP stands close to its 15-year average compared to a 15% over-valuation for the broad-trade weighted dollar,” says the bank.
“This points to America’s [emerging markets], not [developed markets] trading partners as still substantially lagging the FX adjustment. The last three dollar cycles have seen the OITP dollar over and undershoot fair value by more than 10% suggesting there is plenty more upside in the dollar here.”
Based on this view, Deutsche expects the US dollar will outperform against emerging market currencies, including against the Chinese yuan, a somewhat ominous view given the drama created when the yuan weakened against the dollar at the start of 2016.
“We prefer expressing a bullish dollar view against the Fed’s OITP index over the summer months in recognition of better valuations, stretched EM-US data surprises, a low correlation with Fed fund expectations and bearish flow signals,” says Deutsche.
“We would buy USD against the OITPs, proxied by the following seven largest weights: 46% CNH, 27% MXN, 9% KRW, 5% TWD, 5% BRL, 4% INR and 4% SGD.”
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