Analysts say the greenback's rally will run out of puff

DANIEL LEAL-OLIVAS/AFP/Getty Images
  • ANZ analysts say the US dollar strength may run further but they are “mildly bearish” in the long-term.
  • While they expect the euro and Japanese yen to strengthen, the AUD is likely to remain under pressure.

Broad-based strength in the US dollar has been a key talking point in markets this week.

ANZ analysts Daniel Been and Giulia Specchia say while there may be some more near-term upside, the rally is unlikely to last.

But they argued that any falls in the USD will be driven by renewed strength in the euro and Japanese yen, rather than cyclical currencies like the AUD and Kiwi dollar.

The USD got another boost from further falls in the euro overnight, after ECB President Mario Draghi took a measured view towards Eurozone economic outlook following the central bank’s rates announcement.

The move helped push the US dollar index (DXY) to a new four-month high at 91.55.

While a falling euro was the impetus for last night’s move, a key trait of this week’s USD rally has been the broad-based strength of the greenback against all major currencies.

Been and Specchia said developments in bond markets — with US 10-year bond yields pushing above 3% for the first time since 2014 — have no doubt played a role in that.

The pair highlighted how the correlation between the DXY index and a higher yield spread on US 10-year bonds has recently started to strengthen again:

They noted that when the correlation does start to rise, it usually lasts for a period of six to eight weeks.

“This suggests that, if bond yields continue to rise (as we believe), we may see some further USD strength in the short-run,” they said.

However, the analysts said that while the US Fed may be further ahead in its tightening cycle, other central banks are slowly beginning to normalise too.

So the relative move higher in bond yields is unlikely to long-term catalyst for US dollar strength.

The greenback’s run higher has also been exacerbated by market positioning. In other words, a large number of traders held positions that were either betting on a fall in the USD or a rise in other major currencies.

With the USD now rallying, those positions need to be unwound.

Been and Specchia noted how the currencies with the largest net-long positions against the USD are also the ones that fell the most in the week’s USD rally:

Their analysis follows Bank of America-Merrill Lynch’s monthly survey of global fund managers in mid-April, which showed short-USD positions were seen as the second-most crowded traded in the world.

In addition, recent economic data is more indicative of a stronger US dollar — as evidenced by a Deutsche Bank report which showed the US is now the only G10 economy with positive data surprises.

But on the data front, Been and Specchia said the gap that’s opened up between the US and other major economies is unsustainable — particularly against the Eurozone.

“This suggests that one of the two economies will soon change course. That is, either the Eurozone will start to surprise positively — which is reasonable, given expectations are being revised lower — or the US economy could start to consistently disappoint.”

And while the US government is so far yet to comment on the greenback’s rally, President Trump has generally angled for a lower USD since he took office.

“On net, while we think the current squeeze higher in the USD may last a bit longer, on a medium-term basis we remain mildly bearish,” the analysts said.

They said that once market positioning has fully unwound and other central banks stay on track to normalise monetary policy, the market will return to trading on risk appetite instead.

In that environment, the Aussie dollar is likely to struggle while the euro and yen may see increased demand against the USD dollar.

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