Westpac says the headwinds for further US dollar strength are building

  • The US dollar index (DXY) has been on a tear in recent weeks, rallying close to 5% since mid-April.
  • Westpac Bank says the headwinds for further US dollar appreciation are building.

The US dollar index (DXY) has been on a tear in recent weeks, rallying close to 5% since mid-April.

It’s been a stark turnaround from just a few months ago when the greenback was clearly on the nose.

DXY Chart

The question now is what will happen next? Is this the start of a longer-term trend shift or just a corrective bounce after more than a year of near-constant selling?

To Westpac Bank’s FX strategy team, the USD is looking good near-term, particularly with benchmark 10-year US bond yields climbing back above 3% on Wednesday.

“The latest run up in yields toward 3% has a much more ‘USD friendly’ quality to it, coming less from term premium and moreso from rising Fed hike expectations, unlike than the earlier new year run up in yields, thoroughly ignored by the USD,” it says.

However, pointing to signs that wage and economic growth may start to slow from here, Westpac doesn’t expect the rally in the greenback will continue unabated, suggesting that “it won’t have it all its own way”.

“Private sector wages and salaries may have hit a post-crisis high of 2.9% but not all measures of labour costs are accelerating uniformly,” it says, pointing to the chart below showing various measures of wage pressures in the US.

Source: Westpac Bank

“The employment-population ratio for prime aged workers has consistently tracked US wages growth more reliably than other indicators and earnings growth of 3-4% is more typically only seen when the this statistic is above 80%.

“On current trends it will take almost two years for the ratio to hit that level.”

Source: Westpac Bank

Adding to the headwinds for a sustained and large rally in the dollar, Westpac says “the bullish reprofiling of US growth expectations has run its course”.

“Tax cuts, fiscal stimulus and accommodative financial conditions have fueled a significant uplift in growth expectations for 2018, from the low 2% region to around 2.7-2.8%,” it says.

However, with financial conditions in the US not as easy as they were earlier in the year, Westpac says that could prevent a further lift in US growth expectations, leading to greater headwinds for further US dollar appreciation.

Source: Westpac Bank

“The relentless easing in US financial conditions has come to an end,” it says.

US financial conditions are not tight, far from it, but the mix of weaker equities, wider credit spreads, higher mortgage rates, yield curve flattening, a modest correction higher in the USD and higher LIBOR-OIS wholesale funding rates have all finally produced a measurable turning point in various measures of US financial conditions.

“Growth expectations are unlikely to turn lower, if at all, but the trend of persistent upward revisions has probably crested.”

Throw uncertainty generated by the US mid-term elections in November and Westpac says the DXY is unlikely to rally much higher from here.

“The structural drag from the ‘twin deficits’ is likely to reassert itself,” it says.

“Conditions for sustained DXY strength deep into the second half of the year are not propitious. It can rally to 95-96, retracing about half its 2017/early 2018 decline, before stabilising.”

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