BANK OF AMERICA: The US dollar is overvalued, and there are ‘substantial risks’ to a big rally from here

Ice climbing

The US dollar is the worst performing G10 currency this year, down 8% versus its major peers. But it’s still expensive relative to its history, according to Bank of America Merrill Lynch.

“The currency remains overvalued by about 10 per cent compared with its long-term equilibrium and about 12 per cent above its 20-year average in real effective term,” said Athanasios Vamvakidis, the global head of G10 FX strategy, in a note on Tuesday.

A combination of tax reform and stronger economic data, or even just one of the two, would be sufficient to stoke the dollar, Vamvakidis said.

“Both remain our baseline assumptions, although with substantial risks, particularly on the chances for tax reform,” he added.

But that’s not likely to stop the greenback from grinding higher in the near-term. Vamvakidis forecast that one euro would weaken to be worth 1.08 dollars by the end of the year, down from around 1.1688 on Tuesday.

It’s a similar thesis to one being put forward by many equity strategists. Yes, the stock market is expensive by various measures of valuation. But no, that doesn’t mean a crash is imminent. The market has support from various sources to keep rallying, including strong company earnings and a stable US economy.

“We have not given up yet on US tax reform and infrastructure spending,” Vamvakidis said. “Related uncertainty could explain some of the weakness in the US data this year. This suggests that good fiscal news could support the US economy and the USD, directly, through the fiscal impulse, and indirectly, through private demand because of less policy uncertainty.”

Bets on the dollar’s direction do reflect some caution among traders. According to Deutsche Bank, bearish positions on the dollar per the Commodity Futures Trading Commission reached the highest level since February 2013 last week.

“The market is short the USD, but this position is not stretched, with the exception against some EM FX,” Vamvakidis said.

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