Across the board, the dollar's strength has been driving foreign
exchange flows for the last few quarters. By now, every investor is well
aware of the macro-factors driving the greenback to fresh multi-year
highs: an inevitable rate hike by the US Federal Reserve and the
autopilot easing mode of the European Central Bank and the Bank of
Japan. If one lays out the same reasons for the next leg of the dollar
rally to a greenback bull, the response will most likely be: tell me
something I don’t know. Thus, at this juncture, monetary divergence
seems to be priced in the dollar's strength.
Historically,
each greenback rally has been roughly 20 percent (with the exception of
the early 1980s and mid-1990s) based on the US Dollar Index, according
to HSBC. The current rally already seems overdone according to
historical price action. The US Dollar Index is up by over 25 percent
since June, 2014, and up over 40 percent if we were to take the 2011 low
as the starting point.
There is much debate over the timing of
the first US Fed hike: it may come in June or September. Recent data
actually suggests it may well be pushed to next year. Positioning has
become universally bullish leading up to this event and the dollar now
remains exposed to a sharp reversal. The bond market or the Federal Fund
futures have already priced in a rate hike this year and subsequent
hikes next year. So, unless one is of the view that Fed chief Janet
Yellen is going to be more aggressive than market expectations on her
normalization path, there is no reason to jump on the dollar bandwagon
at these prices.
Further, as has been proven many times in the
past, central bankers can kill a currency’s strength at any press
conference. Theoretically, a stronger dollar is already doing the
tightening work for Yellen. The US Fed has already highlighted that a
strong dollar will make inflation lower than would otherwise be the case
and a slight change in Yellen’s language arguing against relentless
dollar strength can be a trend changer for the greenback. The US
presidential elections in 2016 could encourage members of Congress to
become more vocal about the adverse impact of a strong dollar on their
constituents, according to HSBC.
On the valuation metrics - The
Economist’s Big Mac index, the OECD measure of purchasing power parity
(PPP) and the current real effective exchange rate relative to the
five-year average - the dollar seems the world’s most overvalued
currency behind the Swiss franc, according to HSBC. But this, in itself,
cannot be an indicator that the dollar bull-run is nearing its end.
Currencies often trade well outside of these valuation bands and can do
so for extended periods of time.
Lastly, and most importantly,
it is essential to note that the dollar tended to fall after the first
actual rate hike after each of the four US Fed tightening cycles. What
determined the medium-term trend for the dollar was whether the rate
hikes were a response to an inflation problem or whether a stronger
economy was driving rates higher. A strong economic recovery led the
greenback higher in most cases. But this time around, US economic
activity still has not found that ‘escape velocity’ to warrant a big
bullish on the dollar from here on.
The biggest risks to a short
dollar trade are obviously further turmoil in the euro zone and a need
for additional easing by the Bank of Japan as they are still
undershooting their inflation target. There is strong talk about the BoJ
announcing further easing measures (some form of the Fed’s Operation
Twist) in July. This may send the euro towards parity and the yen
towards 130 against the dollar sooner than many would have thought.
It
often pays to be a contrarian in such one-sided and crowded trades. But
for the time being it is still very hard to call a top on the dollar
for now as momentum can take the US Dollar Index past 105. Shorts will
have to wait for serious cracks to appear in the dollar story before
making their move.
(16.04.2015. Vatsal Srivastava is consulting
editor for currencies and commodities with IANS. The views expressed are
personal. He can be reached at [email protected])
