UBS warns the era of US dollar 'exceptionalism' will soon be over

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  • The US dollar has been the comeback story of 2018, recovering after significant weakness in 2017.
  • UBS doesn’t expect its recovery will last, suggesting the era of US dollar “exceptionalism” will soon be over.
  • It outlines for specific factors that look set to weigh on the US dollar index (DXY) next year.
  • UBS says the euro and Scandies are likely to strengthen against the greenback. It also anticipates better times for commodity currencies, especially the Australian dollar.

US dollar strength has been the major theme for currency markets this year, a performance in stark contrast to what was seen in 2017 when it was among the worst performers globally.

However, UBS doesn’t expect the renaissance in the buck will last, suggesting the era of US dollar “exceptionalism” will soon be over.

“We expect the US dollar index (DXYT) to weaken by about 6.5% to 91 in 2019,” the bank’s Global Macro Strategy team says.

“This expectation rests on four overarching views — US front-end yields have limited upside, the USD will continue to have a higher sensitivity to foreign yields, foreign real yields are too low relative to output gaps and money market curves outside the US are too flat and the USD is fundamentally expensive.”

Put simply, with markets already expecting further monetary policy from the US Federal Reserve, and not enough risk being priced for tighter policy from other central banks given current economic conditions, UBS believes the US dollar will weaken from expensive levels.

“Tightening expectations outside of the US remain largely under-priced,” UBS says.

“Looking at central banks in Europe that are likely to embark on policy tightening next year or have just done so, the market is pricing in only around 35 basis points (bp) of hikes by the ECB over the next two years, 60bp in Sweden, and 50bp in Norway.

“The RBA and RBNZ may not be tightening in the next 12 months, but money market curves there are also extremely flat, each pricing in only around 10bp over the next two years.”

UBS says the lack of market expectation for policy tightening is not unusual, noting markets tend to “discount little in terms of the tightening cycle until the central bank’s first move”.

“We have seen this play out ahead of the first hikes in the US, Canada and, most recently, Norway where front-end yields picked up significantly a couple of months before the first hike,” it says.

“This explains why currencies tend to react strongly to the first hike.

“This scenario could be replayed in 2019.”

But which currencies, in particular, will strengthen against the greenback?

UBS says there are a few candidates out there, headlined by the euro.

“Our view on the importance of growth, tightening expectations and under-priced central banks outside the US applies predominantly to Eurozone growth and ECB policy,” it says.

“In fact, we expect EUR directionality to anchor most of G10 FX in 2019.”

UBS expects the GBP and CHF to “underperform the most [against the euro] as a result of ECB policy normalisation,” although it expects policy normalisation to have the opposite effect on the Scandinavian currencies such as the SEK and NOK.

“They remain among our favourite ways to express a positive view on domestic fundamentals and policy normalisation, with a positive beta to European recovery without political risk,” UBS says.

“In relative terms we prefer SEK to NOK because of the more favourable inflation dynamics and more modest central bank expectations in Sweden.”

Given the expectation that 2019 will be the year of the “central bank handover,” UBS is also warming to the Australian and New Zealand dollars, two G10 currencies that have been hit harder than most in 2018.

“Commodity currencies should perform better in 2019, led by AUD which is cheap even relative to already conservative domestic tightening expectations,” it says.

“In addition, China and trade risks are in the price to a large extent.”

It adds that upside in the NZD is “more limited owing to RBNZ dovishness,” something the bank says may not be sustainable given “relatively solid fundamentals”.

As for when the US dollar will begin to retreat, UBS says is could be a story for the second half of 2019, rather than from the outset.

“Weakening global growth momentum in conjunction with the fiscal offset in the US implies that the dollar correction may take some time to materialise,” it says.

“From here, a more active phase of USD weakness would require stronger risk sentiment and a positive shift in global growth momentum.”

Here’s the latest G10 currency forecasts from UBS.


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