Interest rates have been surging in the United States as concerns grow in the marketplace that the Federal Reserve will slow its bond purchases sooner than expected as economic data improves.
Yet the U.S. dollar index hit its lowest level since mid-February this morning, which seems counterintuitive – rising real interest rates should coincide with dollar strength (in recent months, the performance of the dollar has become correlated with risky assets like stocks as investors make bets on a U.S. economic comeback, whereas before, it was the opposite).
Citi strategists Valentin Marinov and Josh O’Byrne say that “Why is dollar so weak? Will it last?” may be the most frequently asked question these days.
So, what’s the answer?
Marinov and Byrne point out that dollar weakness as of late is only against a few certain currencies – the euro, the yen, the Swiss franc, and the British pound.
(The commonly-quoted U.S. dollar index is actually weighted 57.6% against the euro, 13.6% against the yen, 11.9% against the pound, and 3.6% against the franc, with the Swedish krona and the Canadian dollar rounding it out.)
Marinov and O’Byrne write:
So what is driving the dollar underperformance relative to EUR, JPY, CHF and GBP? The move can be explained by a combination of factors. We have highlighted in the past that investors maybe worried that a potential re-run of the 1994 episode, when the Fed was similarly moving closer to exiting easy policy, could leave the dollar vulnerable as the markets start to worry about the impact of rate tightening (QE tapering) on the USD-denominated assets.
We would also argue that some of the dollar underperformance could be related to the upcoming FOMC meeting next week. With market sentiment tanking and with both the ECB and the BoJ refusing to take measures to contain volatility, investors may be betting on more dovish Fed next Wednesday to try to dial down its tapering rhetoric. This leaves the dollar vulnerable against JPY and especially EUR.
Another driver of the USD underperformance could be the unwinding of dollar longs especially against JPY. Given that USDJPY depreciated by 20% between January and May this year, we could see some further positioning squeeze there. In the case of EURUSD we think that the resilience of the pair is related to continuing positioning unwind of euro shorts vis-à-vis G10 smalls.
The Citi strategists think the dollar weakness is only temporary, especially if the Fed fails to strike a dovish tone at next week’s FOMC meeting.
“It is also worth highlighting that the latest back up in UST yields is not inconsistent with the steadily improving US economic conditions,” say Marinov and O’Byrne. “We think that growing dollar rate advantage and further repatriation into the US should remain supportive for the greenback from here.”
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