The US dollar is in rally mode. It first picked up steam as the 10-year Treasury yield edged towards the psychological level of 3% which it eventually breached.
Helped by a lift in short- and long-dated US bond yields to fresh multi-year highs while geopolitical risk perceptions have tentatively waned, the greenback has rallied close to 3% since late March.
As the US dollar broke out on higher interest rate expectations, lofty bond yields also weighed on equity markets. Major stock indexes struggled to gain footing despite what has generally turned out to be a positive earnings season thus far.
They were haunted by the looming ghost of potentially higher inflation and interest rates despite many major index components, most notably in the financial and technology sectors, delivered results significantly better than expectations.
The movement in the US dollar suggests a major shift in sentiments that could turn out to be short term supportive for the currency with the potential of it turning into a major event.
Weaker than expected data out of Europe and lagging stories from UK and Japan may have faltered a bit on their growth and monetary policy stories.
With the euro, pound, yen and regional currencies all struggling against a resurgent US dollar, this trend could continue for a short while. Aside from the continuing focus on rising government bond yields, the Fed’s decision to hold rates in the recent FOMC meeting fell in line with our expectation after the March rate hike, suggesting a total of three rate hikes in 2018, most likely in June and September.
Still the Fed may likely be on track to deliver four rate hikes this year instead of the three that we targeted in early 2018. The fourth rate hike is more likely to happen in December where the probability stands around 40% chance to materialise. Such a likelihood should boost the US dollar for a while.
The question is whether the rally in the greenback will continue, or reverse, in the period ahead?
The greenback is more likely to continue its rally at least in the near term. With the bond yields rising, it has lent support to the US dollar. Although the greenback does not always correlate highly with US yields, still, correlation between them tends to be high when both are rising. The relationship does last for close to about three months.
On that note, there are possibilities for this positive US dollar trend to continue in the second quarter with the US bond yields still moving higher and support for a stronger US dollar.
However, in the process the greenback is poised to experience some pullback from its upward trend.
The reason being, the link between currencies and interest rate divergences reignited when the European Central Bank acknowledged the weaker economic data unveiled of late. But this could easily swing the other way, as expectations are for the eurozone data to improve in the near term.
Besides, it would take just a few words from the US Federal Reserve to reverse this strong US dollar trend.
If one traces the behaviour of the US dollar in late 2017, the currency saw a decent correction between October and December when the hope for the tax plan drove it higher.
However, the greenback rally faded in the beginning of the year. Issues like the high debt burden and current account position caused discomfort and resulted in a weaker US dollar at the beginning of the year.
But more recently, US dollar bulls focused on the interest rate differentials theme.
They comfortably forgot the greenback’s own problems, which are high debt burden and current account position that weakened the currency at the beginning of the year.
With these problems still there it will be tough for it to be ignored. It means the possibility for these issues to emerge and weigh on the greenback again in the future is on the cards.
So it appears that the behaviour of the US dollar for now may not be fully supported by the fundamental stories. It could also be supported by “short covering”.
The term “short covering” is buying back borrowed securities in order to close an open short position. It refers to the purchase of the exact same security that was initially sold short, since the short sale process involved borrowing the security and selling it in the market.
Hence, the current greenback movement may not be fully supported by fundamentals.
It will raise eyebrows on whether the greenback will also fade out when we get exhausted with the same old stories that offer limited support for the US dollar.
On that note, until the potential incoming data from the major economies starts to unveil more exciting and convincing numbers, the trail of minimum resistance will remain for the market to continue to chase carry and cover US dollar short remains. The moment potential macro incoming data sheds positive light again, the story of weaker US dollar will creep up again.
Thus, the outlook for the euro against the US dollar may not have run out of steam.
The recent weak macro data in Europe has raised some concern on the European Central Bank’s (ECB) plan for a gradual withdrawal of monetary stimulus apart from the potential risk of trade protectionism.
But the eurozone economy lost some momentum in the first quarter partly due to weather and strikes being viewed as temporary.
With healthy global growth and supportive trade in euro area, it should support the data to settle and boost confidence. With such perception that the region should start presenting better data in the H2 of the year, it would mean the policymakers are most likely to communicate on whether to end its 2.55 trillion-euro asset purchase even if inflation falls short of their 2% target either in June or July and lesser of September.
Should inflation remain low, the ECB could consider extending the purchases or have a longer taper. Besides, the ECB has been vocal on their concerns over the stronger currency.
Thus, the current 30 billion-euro bond-buying programme could be reduced further to 15 billion from October and end in December 2018.
Softer demand for yen
As for the Japanese, it has been in a consistent state of free-fall for much of April as the widening differential between the US Fed and the expectations of Bank of Japan to maintain its current monetary policy has become increasingly clear.
A key challenge is that private consumption could be subdued if wage and income growth remains modest. Slow wage growth poses a challenge to policymakers trying to inject further momentum into an economy now in its best run of expansion in 28 years.
This probably explains the central bank’s decision to relax the 2% target for the core inflation in fiscal year 2019 that only caused confusion with no major significant market movements.
Another worry is on the potential threat of US trade protectionism.
Trade friction could result to a big blow to exporters who have benefited from solid global demand. Japan’s swelling current account surplus above two trillion yen is good for its finances but may not be so for its relationship with the US since it becomes an easier target by the US. Trade surplus with the US is around 631 billion yen in February 2018.
Meanwhile, the bigger event was the Korean Summit.
Here, the leaders of North and South Korea met at the border.
They have come to a decision to denuclearise the peninsula and reach a peace treaty. This has reduced the geopolitical tension and has lowered the demand for the safe haven currency, ie the yen.
The poor run on the British pound may not last.
Recent below expectation figures led to the view that slower economy will continue in the H1 of 2018. But the weak Q1 of 2018 economic growth was partly due to the weather and the British pound took a knock. It could result to the postponement of a rate hike by the central bank of UK in May.
Though in the near term, volatility is expected to surround the pound, room for the currency to rebound remains.
It will benefit from a better economic performance in H2 of 2018. Retail sales should pick up after being hurt by the bad weather in Q12017, while real disposable incomes are starting to rise as inflation subsides (2.5%) and nominal wages grow (2.8%). Labour force participation rate is at 75.4% with house prices becoming stable.
With the expectation of a pickup in data, the possibility for the next rate hike to be in either August or September should see the pound gain momentum.
However, we should not jump into an optimistic outlook that soon on the pound. For the pound to drop further, we need to see a significant spike in UK political uncertainty. At the moment signals from UK politics and Brexit are vague.
Ringgit still has upside
Mixed incoming macro data somewhat contained the slide in the Malaysian ringgit against the US dollar.
Although the ringgit is expected to experience volatility along the path, the downside risk remains fairly contained, supported by the macro fundamentals.
Economic growth will be supported by domestic demand, ie private consumption while investment remains supportive of the recovery sustained by a buoyant business sentiment, the need to upgrade the capital investment and rising profits.
The ringgit will benefit from the country’s strong linkage in the global supply chain amid robust global export volumes.
Expectation of improving public finances, surplus current account, healthy reserves and foreign appetite in the local bourse and bonds space will continue to support the ringgit. Onshore sentiment on the local currency has improved.
Although Bank Negara is expected to maintain the accommodative monetary policy with the aim of supporting growth and stabilising inflation, the possibilities for another rate hike could happen if the demand-pull inflation kicks in strongly and the US Federal Reserve moves into four rate hikes.
And the undervalued currency based on fundamental analysis as well as real effective exchange rate will provide support to the ringgit.
Anthony Dass is the chief economist of AmBank Group.