Something strange is underway in currency markets at present.
Even though the US Federal Reserve continues to lift interest rates, widening the interest rate differential to many other major nations, the US dollar has been hammered.
The narrow US dollar index, or DXY, has fallen by close to 15% since early 2017, partially reversing the enormous rally that began in mid 2014.
Given the US Fed hiked interest rates three times in 2017, it has perplexed more than a few traders who became accustomed to interest rate differentials driving currency market movements in the post global financial crisis era.
While the disconnect between the DXY and interest rate differentials suggests that something has recently gone amiss, to George Saravelos, Currency Strategist at Deutsche Bank, what’s happening now is not all that unusual, merely a return to what used to drive currency market movements before the GFC hit nearly a decade ago.
“Viewed with the post-crisis lens of activist central banks and exceptionally tight correlations between FX and rates the dollar is entirely out of line with fundamentals,” says Saravelos.
“Take a step back to the 1990s and 2000s however and things look a lot less unusual.
“Back then, the correlation between US yields and the dollar was very weak. FX market drivers were influenced by the complex interaction of macro variables, politics and valuations.
“The deviation between rates and FX was the norm, rather than the exception,” he says.
This chart from Deutsche Bank shows the value of USD overlaid against interest rate differentials between the US and the rest of the world.
After a period when the US dollar was driven by interest rate differentials, shown in the dotted red box, the relationship has broken down recently with the dollar weakening despite interest rate differentials continuing to increase.
To Saravelos, the recent disconnect is largely explained by capital flows, rather than rate differentials.
“Currency moves over the medium-term ultimately boil down to one thing: flows,” he says, adding that “if inflows into an economy pick up the currency strengthens and vice versa”.
“Looked at from a flow perspective, the dollar bear market makes complete sense.
“The US basic balance — the sum of the current account, portfolio balance and foreign direct investment flows — peaked last year and is on a steadily declining trend.
“The European basic balance, in contrast, is shooting up,” he says, pointing to the chart below showing the contribution of foreign direct investment, current account and portfolio flows to total capital flows to the euro area.
That may explain why the euro has rallied over 20% against the greenback since early 2016, leaving it at the highest level since early 2015.
Saravelos says given the current trends in capital flows, along with a more stable political climate in Europe, provides “the perfect cocktail for continued euro strength”.
“Europeans have spent trillions of euros recycling their current account surplus abroad over the last few years, a phenomenon which we have previously termed ‘Euroglut’,” he says.
“This flow drove EUR/USD all the way down from 1.40 to parity. As a result, Europeans are exceptionally overweight foreign assets. In the meantime, Europe’s current account surplus has swelled to EUR 400 billion a year.
“As these European outflows begin to normalise, even a small change makes the Eurozone basic balance look a lot more positive.”
And with US asset valuations stretched and US current account deficit widening, Saravelos says that should see the euro continue to strengthen in the year ahead.
“Turning points in the medium-term dollar cycle are often marked by material geopolitical events,” he says.
“We would argue the medium-term bear market in the dollar started with the inauguration of President Trump and President Macron in the US and France, respectively, last year.
“It has coincided with a structural shift in the relative flow dynamics between the US and the rest of the world.
“We continue to target 1.30 in EUR/USD for this year.”