Economic focus - February 2018
Dollar – More weakness ahead?
- After a rally from 2014 to early 2017, the dollar index has lost significant ground, erasing half its gains.
- However, the dollar recently bounced as participants started to fear more aggressive monetary tightening in the US following strong inflation data.
- We expect the dollar to lose further ground versus the euro in 2018 although an inflation-induced repricing of Fed rate hike expectations could provide a temporary boost
Last year saw mixed currency trends. While the dollar fell 10% after a 30% rally from mid-2013 to late 2016, the euro recovered around 15%, correcting more than half the losses recorded since 2014, and sterling rose gradually, approaching pre-Brexit levels. Meanwhile, emerging currencies regained ground versus the dollar thanks to the global recovery, higher commodity prices and stronger exports.
Although the US Federal Reserve (Fed) is more advanced in normalizing its monetary policy, with a first rate hike in December 2015 and a reduction of its balance sheet since October 2017, we expect the dollar to stay under pressure for structural reasons.
What explains the dollar rally these last few years?
1. Robust growth. The United States have recovered stronger and faster than the other developed countries, helping the dollar pick up. Expectations for higher inflation in light of the shrinking economic slack in the US have been disappointed, curbing US rates and flattening the yield curve.
2. Monetary policy divergence. Since the European Central Bank (ECB) embarked on quantitative easing in March 2015, markets have priced in policy divergence between the ECB and the Fed, causing euro weakness and dollar strength.
3. The performance of US assets. US firms have benefited from robust growth, driving flows into equities. Also during cycle upturn, the dollar tends to outperform the other developed market currencies.
Why do we expect further dollar weakness?
1. Tighter growth gaps. Although US growth will remain strong thanks to the tax boost, the growth gap with the eurozone will narrow. Key emerging economies are exiting recession and activity in China has surprised on the upside.
2. A shift in political risks. Political risks have shifted from the eurozone to the United States. The defeat of populist parties in several European elections in H1 2017 revived hopes for institutional reform in the eurozone, helping the euro recover. Conversely, the United States have been regularly faced with political gridlocks such as the recent government shutdown.
3. Monetary policy expectations. While the yield gap between 10-year US and German sovereign bonds peaked at 235 basis points in December 2016, the differential between US and eurozone short rates has only narrowed somewhat. The focus is now more on monetary policy guidance in the eurozone.
4. The dollar is overvalued. A year ago, the dollar hit a cyclical high and started to correct lower. We believe there is more to come as it remains expensive.
We expect the dollar to lose further ground versus the euro in 2018 although an inflation-induced repricing of Fed rate hike expectations could provide a temporary boost.