FX Watch – Cyclical bond flows support USD

by: Georgette Boele

In this publication: Currently the US dollar is behaving like a cyclical currency, meaning that relative economic growth performance and Fed rate hike expectations are key. Net cyclical bond flows have strongly supported the dollar and we expect this to continue during our forecast period. Meanwhile, net equity outflows have been a major headwind. US dollar could also behave as a safe haven currency, then the relationship with cyclical US assets is negative.

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Introduction

In this FX watch we look into the importance of net inflows into US securities for the US dollar. We take into account how these flows behave and the character of the US dollar. Since September 2012, the US dollar has mainly been driven by cyclical factors (with the exception of February to May of this year). This means that the US dollar is sensitive to expectations about Fed interest rate hikes and relative economic growth performance. In such an environment, in general, higher rate hike expectations and higher US equities support the US dollar.

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Confirmed by flow data?

Given the cyclical nature of the US dollar over recent years it would be expected that foreigners would have bought US cyclical assets like US corporate bonds and /or US equities. Has this been the case? The graphs above confirm that this has been the case. The start of the US dollar rally in H2 2012 was mainly driven by foreigners buying into US equities (graph on the left). Two years later, the US dollar received a major boost from foreigners buying into US cyclical bonds. This was mainly driven by expectations of higher yield pick-up in US bonds compared to other non US assets (see graph below).

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Cyclical US dollar for now…

As stated above, the US dollar behaves like a cyclical currency. This means that prospects about US economic growth and the Fed remain the main driving forces. We expect US growth to be moderate and the Fed to remain on hold this year and to hike in total 75bp next year. We expect the 10y US-GE yield spread to remain roughly stable around these high levels as German yields gradually move up from their lows. As a result, foreigners will likely continue to buy US cyclical bonds.

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However, equity flows are not supportive at all. Since Q1 2013 they have declined and since the end of 2013 the US has even experienced equity outflows, despite the fact that US equity indices have risen to new all-time highs. The rise in US stocks has been possible because of the buying of domestic investors. The equity net outflows have resulted in a major headwind for the US dollar. With US equity markets at these high levels, it remains to be seen if foreigner investors will return to buying US stocks.

…but the US dollar can also behave as safe haven currency

What makes the US dollar difficult to analyse is that it can also behave as a safe haven currency. This is because the US dollar is the most liquid currency and US markets are the deepest and the most liquid. In periods of severe stress, investors search for the most liquid assets such as the US dollar, the Japanese yen, US Treasuries and German Bunds. The graph and the table below show the periods in which the US dollar behaved as safe haven (red circles) and as cyclical currency (green circles).

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If investors flee to the US dollar because of panic it is likely that they will keep it on account/in cash and this will not be captured in the flow data. However, what is visible is the lower demand for the more risky US assets such as equities and corporate bonds. Therefore, in periods of risk aversion, when the US dollar behaves as a safe haven currency, the US dollar will rise while flows into US equities, corporate and agency bonds will slow down. While if sentiment improves the US dollar will move lower and these flows will pick up.

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This year there was a short period from February 2016 to May 2016 in which the US dollar behaved as a safe haven currency. Will the US dollar behave like a safe haven currency in the future again? This is likely if risk aversion would develop into severe stress in financial markets. As the US dollar is now more driven by cyclical drivers, some deterioration in investor sentiment will initially weigh on the US dollar. If investor sentiment continues to deteriorate at some point in time investors will prefer liquidity over yield pick-up. So the US dollar will increasingly receive support from safe haven demand until the crisis develops into a climax. From that moment on, the US dollar will decline, also if investor sentiment improves, until the moment that investors believe that US assets will outperform non-US assets.

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