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The quiet life of the greenback

Teaser: The USD-PHP exchange has continuously gone up throughout 2018 partly due to a weaking peso. But even though the U.S dollar is fairly stable in a certain way compared to other major currencies, it is showing signs of weakness.

The U.S. unemployment rate is at its lowest over the past 50 years, and of course, the American economy is robust. At the same time, the U.S. central bank Federal Reserve Bank (Fed) raises interest rates every quarter. This again pushes the entire yield curve up, including the important 10-year U.S. treasury yield.

If one looks further around the world, the oil price has gone up together with other commodities and investors have fled from investments in Emerging Markets. Within the past 6 to 12 months, there has been quite a movement in many factors that should, or at least could be able to, move the U.S. dollar, also called the greenback among friends. However, as a graphic one shows, the dollar against the euro fluctuated around 1,1500 plus / minus 2.5 pct. since mid-May, which underlines a surprisingly quiet life for the greenback at the moment.

When the Fed was so constant in hiking the interest rates, I have noticed more participants in the financial markets who wonder why the dollar hasn’t trended higher since May. One could argue that Fed has communicated so well to the financial markets, that the interest rate hikes are expected, and thus already priced in the exchange rate.

However, this is rarely the market mechanism, because in a foreign exchange rate, it’s difficult to price in a new future cash flow. The expectations can be priced in the short-term markets with 3- and 6-month durations, which making it more interesting to buy a currency ahead of an interest rate hike. But my own experience shows that it is primarily after the increase in interest rates, and usually after more hikes, that the positive effect of a currency becomes noticeable – which precisely is the case for the dollar.

Lately, some Emerging Markets countries have woken up and figured out that they need to follow the American interest rate hikes in preventing too much capital flight and protect their own currencies against too much pressure. It means that a growing number of countries in the world are hiking the interest rate, which I expect will intensify in some of the old western economies such as Canada, United Kingdom and Sweden. In relative terms, this partly reduces the attractiveness of higher U.S. dollar interest rates.

When interest rates are put into play to forecast trends in the foreign exchange market, I pay a big attention to the development between 10-year rates in the US and the EU, especially in Germany. Of course, the euro / dollar exchange rate is not representative for the whole world, but it is still of significant importance in the global financial markets. In my view, it is still the most important foreign exchange rate in the market.

The 10-year government bond yields are shown in graphic two, where the spread continued to expand over the course of this year. I expect the interest rate spread to increase further, and I still argue that this rising interest rate differential is the main reason for a further strengthening of the U.S. dollar against the euro.

As one can see, the widening of the spread this year not been significant nor rapid, despite three U.S. interest rate hikes this year, and a fourth coming in December. This slow movement in the interest rate differential can be an explanation to the dollar’s quiet life, but I also see other reasons.

The euro rose throughout 2017 in a belief that the French President Macron could bring new movement in the Eurozone economy and even reform France. But it is difficult without any fiscal firepower, and since then, the belief in a miracle in Paris has disappeared quietly. Instead, investors have accepted the strength of the U.S. economy and through the first months of this year the Fed cemented the prospect of more interest rate hikes. This finally helped boost the greenback in April and May this year, but at the same time, the new Italian government began to make budget noise and generate uncertainty about the Eurozone, thus causing a weaker euro.

Despite my assessment of a rising dollar during the next six months, the strength of the greenback is not convincing. France has disappointed, and Italy is again in an ongoing harsh discussion with the EU headquarters in Brussels. On the other side of the Atlantic Ocean, the U.S. economy is strong, and interest rates are on the rise, which all in all, is good tailwind for a currency. Despite this bunch of positive elements, there is no established upward dollar trend. I take it as a symptom that the market uncertainty about the American economy is rising, and there is a lack of trust that the U.S. project is long-term sustainable.

As a consequence, the U.S. 10-year treasury yield has only responded limited to Fed’s rate hikes as part of the financial markets expect the American growth to slow down again, followed by a lower inflation. However, it will not change my view that the coming higher U.S. interest rates will lure more investors, even if the European Central Bank begins to raise interest rates in 2019.

During the past 18 months, I have maintained my argument about a stronger dollar, which at times has been wrong. As mentioned, I keep this view, though there is after all a change in my assessment.

It concerns the strength of the greenback, because I regard the strength as decreasing. As a consequence, I currently do not regard it realistic with an appreciation of, for example, 10 pct. towards the euro and other major currencies in general, where five pct. now seems more realistic.

As an example, I now expect growing uncertainties due to the rising fiscal deficit in the United States which increases my long-term concerns for the country’s economic health – and I am not the only one in the financial markets that have these thoughts.

Further, I see an increasing risk that when Fed in 2020 has finished pushing the 10-year treasury yield higher via the Fed fund interest rate hikes, then the market takes over. I argue that there is an increasing risk that investors will grow their concern about the credit quality, due to the increasing government debt – this scenario will send the 10-year treasury yield even higher in 2020.

Should this forecast become reality, then it’s by the way, time to sell out of the U.S. dollar holding in 2020. Until then, a clear upward trend for the greenback should be the case, but it’s missing, because the dollar’s strength is not present any longer. Despite the many positive factors for the greenback, my changed view is that these factors now can only help the U.S. dollar a handful of pct. higher during the coming few months.

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