FX Watch – Dollar bull-run to continue

by: Georgette Boele , Roy Teo

141120-Dollar-bull-run-to-continue.pdf ()
  • We provide an update for our views for the G4, and present 2016 for the first time
  • Dollar bull-run to continue…and the rally is not in a mature phase yet
  • Monetary policy divergence remains key…
  • …and the euro and the yen to remain out of favour…
  • …but sterling’s potential to be clouded by politics

Dollar bull-run to continue

The dollar rally has further to go in our view. Why is this? For starters, it is likely that US economy will remain strong in the coming two years. For example, we expect US economic growth to come in above its longer-term trend rate and far above market consensus for 2015. Fundamentals are improving. The fiscal deficit has declined at a rapid pace and the current account deficit is at sustainable levels. Moreover, US monetary policy will start to tighten in 2015. The US Federal Reserve has ended quantitative easing and the FOMC appears to becoming increasingly less dovish. We expect the US Federal Reserve to start hiking interest rates in the middle of 2015 and hike by 25bp every other meeting bringing the Fed funds to 1.0% at the end of 2015. We expect the Fed to step this up in 2016 and raise rates at each meeting. Last but not least, other major central banks, such as the ECB and the Bank of Japan, will continue to increase monetary stimulus to guard against too low inflation and to support the economy. These above mentioned factors will provide a major boost to the dollar versus other major currencies. As a result, our currency forecasts reflect the continuation of a strong US dollar in 2015 and 2016.

 Is the dollar rally already in a mature phase?

We don’t think so. After a nine-year decline (2002-2011), the dollar stabilised in 2012 and 2013. In 2013 a nascent dollar upswing ran out of steam. Then they were unsuccessful. A year (2014) later the dollar finally turned up. Why did the dollar finally turn? Mainly because of weakness in other currencies. For example, more substantial monetary stimulus by the ECB and the Bank of Japan pushed down the euro and the yen. These currencies hold a large weight in the US dollar index. Therefore, this index started to rally (see below). In addition, the positive momentum in the US economy has also supported the dollar. What comes as a major surprise is that the dollar mainly rallied on weakness elsewhere. Therefore, interest rate spreads still moved in favour of the dollar in 2014. For 2015 and 2016 we expect a more substantial widening in these interest rate spreads. Therefore, we expect the dollar rally to continue. This time around on its own internal strength.

As noted above, monetary policy divergence remains key

The ECB and Bank of Japan are moving in the opposite direction to the Fed. It is likely that the ECB will continue monetary easing in 2015 and 2016. We expect it to further extend asset purchases to agency debt and corporate bonds . In addition, the Bank of Japan will probably continue its aggressive asset purchases in 2015 and 2016 in order to reach the 2% inflation target and to support the economy.

 The yen and ECB to remain out of favour

Monetary policy easing will put more downward pressure on the euro and the yen versus the dollar in our view. This is mainly because of the strong divergence in monetary policy. In addition, currencies with low or negative interest rates will be used as funding currencies in so-called “carry-trades”. This will only play out in an environment of constructive investor sentiment with relative low currency volatility.

Moreover, investors will be attracted towards the dollar, because of the yield difference with the US, the steep US yield curve and prospect of an even higher dollar. For example, yield seeking Japanese investors are expected to increase their overseas assets with lower currency hedge ratios. This is expected to weigh on the yen. Indeed, recently the Government Pension Investment Fund has announced that they will be increasing their overseas stocks and bonds allocation by about 18 trillion yen based on holdings at the end of June this year. Most Japanese life insurers have also stated in their investment plans for October 2014 to March 2015 period, they will continue to increase foreign bond holdings if domestic yields remain low.

The UK’s EU future will be increasingly debated

Sterling is likely to be affected by political uncertainty. The debate about the UK’s future in the European Union could well heat up in the run-up to the elections in May. The Conservative party – currently the senior partner in the governing coalition – has promised an in-out referendum in 2017. Meanwhile, the UK independence party (UKIP), which has seen a sharp rise in popularity in the opinion polls over recent months, is pushing for an earlier vote. Question marks about the UK’s future in the EU could create uncertainty for businesses about the outlook. This is particularly the case for companies that are based in the UK with an eye to accessing the single market and export-dependent businesses more generally. Therefore, we have reflected this political uncertainty in our sterling forecasts. Once the elections are behind us and the likelihood of a possible exit has decreased, in line with our view, sterling could strengthen again versus the euro. This is because cyclical drivers will return to the fore.  The Bank of England will probably hike interest rates in August of 2015. This is one quarter before market consensus. In addition, the economy will remain strong.

 Upcoming FX Watches

In the coming weeks, we will release the following FX Watches that will provide more details to specific regional themes and our 2015 and 2016 FX forecasts.

–       26 November 2014: FX Watch on CEEMA FX

–       3 December 2014: FX Watch on Asia FX

–       10 December 2014: FX Watch on Latin America FX

–       17 December 2014: FX Watch on Scandinavian FX

–       7 January 2015: FX Watch on Commodity FX including Australian dollar,  New Zealand dollar, Canadian dollar and South African rand