THE US dollar relatively underperform in 2017 despite a 75bps hike by the Fed. It lost ground against most major currencies and a handful of emerging market currencies due to stronger global growth that led to a convergence in growth.
Room for the dollar to continue underperforming in 2018 remains on the table driven by a more positive global growth outlook in 2018, continued export momentum growth in the Asia ex-Japan region alongside the start of policy normalisation in some countries.
In the case of the United States, the Federal Reserve is likely to raise rate three times in 2018, each by 25 basis points from the current rate of 1.5% to reach 2.25% in 2018 and normalise around 2.75%-3.00% in 2019.
The labour market remains tight, which in turn will add upwards pressure on wage growth and skew inflation on the high side. Unemployment rate which ended at 4.1% end 2017 should ease to 3.8% by end-2018 as it becomes more difficult for employers to find suitable candidates.
On the back of potential higher wages, added with inflationary pressure coming from firmer crude oil prices and other general prices like housing, medical care, food and services as the economy continues to stay healthy, the overall inflation in 2018 should be around 2.5% from 2.1% in 2017.
Associated with higher Fed funds rate, there is risk of outward capital flows from the US equity markets as investors seek more attractive relative valuations in other jurisdictions.
Long-term interest rates is poised to head up due to anticipated inflationary pressure, though the rising trend of long-term rates may be for a while, thus adding weakening pressure on the dollar.
Furthermore, weaknesses of the dollar could be masked by a general tightening in global liquidity conditions, causing some level of complacency amongst the global investors.
Financial markets are re-hashing the play of stronger global growth that will result to a firmer energy and commodity prices.
It could adversely impact the US current account deficit.
Also, the current account flows can be temporarily dwarfed by capital or portfolio investment flows.
Hence, it is important to look at the net investment position (NIP) which is simply the net balance between the foreign assets residents of a specific country own less the liabilities of those same residents to foreign investors or lenders.
A country with a large positive NIP balances is defined as a net creditor nation and would have run a current account surplus (and vice versa), example Japan and China.
Still a large relative valuation can influence a marked shift in NIP balances. For instance, since 2009 the United States has a much narrower current account deficit from the preceding 10 years.
But its NIP balance widened to a large negative balance due to the stronger dollar on a relative basis since 2008; substantial increase in US equity values, thus the value of foreign investor’s US equity holdings) and substantial accumulation of US treasuries by foreign official investors.
So the dollar would appear overvalued relative to past historical levels. There is scope for capital outflows should foreign investors “rebalance” their portfolios.
However, if the current account deficit hovers around 2% and 3% of GDP, it is no larger than the deficit the United States ran in the late 1990s, a period of sustained dollar strength and relative appreciation.
Weakening pressure on the dollar and higher long-term rates is expected to come from higher fiscal deficit accompanied from the recent enacted tax package.
Such developments could cause pull back on bond buying and thereby increase the strength of their respective currencies against the dollar.
Furthermore, sentiment in the global currency markets has shifted, with the emerging markets to continue to hold the best argument as commodities and inflation expectations rally.
Developed market currencies like the Japanese yen and euro continues to benefit from a view that inflation expectations are pushing toward the top of their comfort range given the amount of bonds they hold.
While looking at the possibilities of a dollar continuing to fall, it is important to take note that the currency could at some point lead to a rebound.
The total dollar-denominated debt outside the US is at US$10.7 trillion in 1Q2017 and about US$4.99 trillion is owed by the non-financial sector of emerging economies, mainly coming from China about US$2.99 trillion.
Rapid accumulation of debt in emerging economies pose risks for the global economy in the presence of US Fed normalisation as it will raise the borrowing costs which in turn would increase the cost of refinancing offshore dollar-denominated debt by the emerging economies.
It is particularly relevant where the offshore dollar borrowings were raised to purchase or hold financial assets with higher yielding corporate and/or emerging-market bonds.
Sharp re-pricing in these riskier yield-sensitive investments can leave leveraged holders of these assets with large dollar funding gaps. Besides, demand for offshore dollar cash holdings would increase as the debt matures. The borrowers will be competing for the same offshore dollar cash that has been extended to direct bank borrowers.
Net effect would be a strong reversal flow of capital out of emerging markets and an increase in demand for safe assets, leading to negative consequences for the United States with appetite for safe assets i.e. US Treasuries expected to increase and reduce long-term rates, flattening the yield curve. The dollar should strengthen.
Our base case dollar outlook for 2018 is around 88.5–89.5 while more optimistically we expect the currency to strengthen around 90.5–91.5.
Ringgit direction and impact on the financial market
The ringgit appreciated by 8.6% against the dollar in 2017 after depreciating 4.5% in 2016, supported by improving macro fundamentals and a lower risk aversion.
The local currency closed at 4.046 end-2017 with the full-year average at 4.30.
The ringgit is poised to stay healthy in 2018, in tandem with the regional currencies benefitting from a more positive global outlook, continued export momentum growth in the region and policy normalisation in some countries.
At the moment, there is no real concern for the regional currencies including ringgit on further tightening by the US Federal Reserve.
This region’s fundamentals are in a much better shape compared with the 2013 taper tantrum period.
Growth momentum is strong and monetary policy will see some recoupling with the United States.
Hence, portfolio flows into the region that includes Malaysia is poised to stay positive, although the amount will likely moderate from 2017’s levels.
This is because global liquidity is set to ease during the year driven by a decline in major central bank balance sheets against the cyclical growth recovery.
Looking at the ringgit against the dollar in 2018, favourable macro data such as firm economic growth supported by domestic activities i.e. private expenditure, broad base supply growth and exports; improving fiscal consolidation on the back of healthy macro fundamentals and prudent policies which should lower further the fiscal deficit/GDP to around 2.8% in 2018 from its peak of 6.7% in 2009; and healthy external reserves that surpassed the US$100bil mark on Aug 15, 2017 to US$100.4bil and as at end-2017, external reserves stood at US$102.4bil.
Besides, the default risk, which is reflected by the five-year credit default swap spread is at the low 50s, suggesting the risk aversion is weak.
Net inflow of foreign funds into the KLCI is around RM3.6bil year-to-date in 2018, accounting for about one-third of 2017’s net inflow of RM10.8bil.
Although the ringgit has appreciated around 3.9% year-to-date against the dollar, there is still room for another 4%-5% upside. Added with favourable domestic fundamentals, the weakening dollar will also add support for a stronger ringgit.
Hence, our base case outlook for ringgit is around 3.88–3.90 while our best case will be 3.76–3.78 against the dollar.
Anthony Dass is chief economist/head of AmBank Group Research.
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