FX Monthly – Will the dollar still turn up?

by: Georgette Boele

130930-FX-Monthly.pdf ()

The dollar has failed to strengthen as we had expected

Over the past few months the US dollar has failed to show the sustained strength that we had expected. Although US Treasury yields did move higher on anticipation that the Fed would reduce monetary stimulus before long, this was not coupled with a clear brightening in investor sentiment and market upgrades to growth expectations. Instead, doubts about the strength of US economy and uncertainty on the political front have hurt the dollar. In addition, the delay in tapering of asset purchases by the Federal Reserve and a downward adjustment in short-term interest rate expectations were also important negatives.

Dollar still seen strengthening over the next year

We continue to expect the dollar to strengthen in the coming months, though we have revised our near-term forecasts. The stars are still expected to align for the greenback over the coming months and quarters. We are optimistic on the US economy because of the improvement of private sector balance sheets and the shale energy revolution. At the same time, external and fiscal imbalances have also been showing a more positive trend. Finally, interest rate differentials are likely to become increasingly favourable for the dollar. In our view, the Fed’s decision to refrain from tapering is likely just a delay for a few months. We expect the scaling back of stimulus to take place at the December FOMC meeting. The dollar has a high positive sensitivity to interest rates, while once growth expectations are scaled up, the dollar’s correlation with the economic cycle and equities will once again turn strongly positive. So an improvement in growth prospects and investor sentiment should be supportive for the currency. Finally, the dollar remains attractive in terms of long-term valuation metrics.

We have revised our 2013 forecasts

Given that we judge that the drivers for the dollar remain positive, we have kept our end-2014 forecasts for the dollar unchanged. For instance, we still see the EUR/USD at 1.10, and USD/JPY at 120 over that horizon. However, we have adjusted our 2013 forecasts. We expect a lower appreciation path, resulting in a year-end forecast of 1.28 (from 1.20 previously) for EUR/USD and 105 (from 110) for USD/JPY.