The US dollar has a topsy-turvy time in 2017.
After starting the year at the highest level since 2002, the US dollar index, or DXY, slumped over 12% from January to early September, undermined by political concerns, weaker economic data and an improving economic backdrop elsewhere, especially in Europe and China.
However, that slide bottomed on September 8, and the DXY hasn’t looked back since, rising over 4% on the back of hopes for tax reform, faster US interest rate hikes, weaker inflationary pressures elsewhere and a bout of short covering from speculators.
The question everyone is now asking is what will happen next?
Has this just been a corrective bounce, or is it the start of something more?
To Athanasios Vamvakidis, Global Head of G10 FX Strategy at Bank America Merrill Lynch (BAML), it’s likely to be the latter, suggesting there’s likely to be one more leg higher in the dollar rally.
After the summer we made a contrarian call to go long the USD and now we are half way there. While EUR/USD was testing levels above 1.20, we projected a drop to 1.15 by the end of the year. This was based on our expectations for a dovish ECB and a hawkish Fed, both of which have now come true. There is still uncertainty about the Fed’s policy reaction function after changes in its leadership, but we assume that the main goals will remain the same. As a result, we expect the market to move closer to the three hikes that the dot plot sees for next year. Technicals have also turned bullish for the USD.
Vamvakidis is forecasting that the EUR/USD will finish the year at 1.15, down from 1.1630 at present. He also expects the USD/JPY to rally to 118, up from the 113.90 level it trades at today.
As for the risks to his call, Vamvakidis says they’re asymmetrically higher, suggesting that tax reforms would likely deliver significantly more upside for the dollar than other potential risks would to the downside.
We don’t know whether tax reform will take place or not in the US — our baseline projections don’t include it, but we have been more optimistic than the consensus—but if it does happen, we have been arguing that profit repatriation will be very bullish for the USD. We are very surprised that the consensus is still ignoring this issue. Our estimates suggest that perhaps 40% of the money the US companies have abroad is in non-USD currencies. Even if half of this money is repatriated, and taking the lowest end of this range, the USD could appreciate by 5-10%, consistent with the move following the 2005 HIA [Homeland Investment Act].
As for the downside risks, Vamvakidis says they largely revolve around the outlook for tax reforms and monetary policy from the Federal Reserve.
“Timing is a risk as it could take longer for the market to converge to the dot plot and to get clarity on tax reform,” he says.
“If there is no agreement on the debt ceiling in December, tail risks scenarios could unfold, initially weakening the USD as the Fed could stay on hold in December.”