Macquarie warns that a big bear market is coming for the US dollar

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  • The USD dollar index (DXY) has fallen over 14% since early 2017.
  • Macqaurie Bank says higher US budget deficits will see the dollar weaken substantially in the years ahead, using history as a guide.
  • The bank describes the introduction of recent tax cuts as an “unprecedented fiscal experiment”.

The US dollar was slammed last year, losing significant ground against most other major currency pairs.

And that trend has continued in early 2018, sliding to a fresh multi-year lows despite a sharp increase in US bond yields, a factor that up until recently acted as tailwind for the greenback.

So what gives? Why have things suddenly changed?

To researchers at Macquarie Bank, it’s because past drivers of the greenback are now returning to the fore: fiscal policy.

“We feel the rapid deterioration in the US budget and the concomitant increase in funding needs will have a more significant impact than higher US rates,” it says.

“It’s worth noting that the US is about to embark on an unprecedented fiscal experiment, with the general government budget balance set to increase to around 5½% of GDP in 2019, with the structurally adjusted deficit moving above 6%.

“This is a level virtually unprecedented outside of war.

“While the US fiscal position has been on a steady decline for decades, this is the first time we have seen a fiscal deterioration of the magnitude now planned at a period when the economy is operating near full capacity.”

This chart from Macquarie shows the near “unprecedented” fiscal experiment that the US government is about to embark on, running what are likely to be deep budget deficits at a time when US unemployment is already incredibly low.

Source: Macquarie Bank

So why does this expected lift in the US budget deficit matter, especially given it will likely lead to faster US economic growth, higher inflationary pressures and a faster hiking US Federal Reserve?

Using history as a guide, Macquarie says movements in the USD has been correlated with changes in the US general government budget balance over the past 30 years, pointing to the chart below.

Source: Macquarie Bank

“The dollar appreciated 32% between 1995 and 2002, as the Clinton government tightened fiscal policy, and then slumped 25% between 2002 and 2008, as the budget deteriorated following the Bush tax cuts,” it says.

“With the budget deficit now set to move beyond 5% of GDP in 2019, we see the current situation as a repeat of the previous cycle. Specifically, in conjunction with a worsening trade balance the deteriorating budget balance will cause a US dollar depreciation.

“This is despite our expectation of a modest increase in both short and long-term interest rate differentials and some repatriation flows associated with the US tax reform package.”

In its opinion, that means the dollar selloff that began in early 2017 has a long way to run yet, pointing out that the USD has tended to moved in large multi-year cycles over the past three decades.

“We now feel that the dollar is in the early stages of a bear market, with the most likely outcome that the US real effective exchange rate falls from its current level of around 120 to the low seen in the early-1990s and early-2010s of around 95,” Macquarie says.

“We expect the EUR/USD to rise to 1.33 by end-2018 and 1.40 by end-2019 and USD/JPY to fall to 100 and 95, respectively.”

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