Bannockburn Global Forex –
February 2018 – USD Weakness
January saw extended USD weakness pretty much across the board despite little obviously significant news and no notable movement in yield spreads. While some ascribed USD weakness to evidence of reduced enthusiasm for higher rates in the FOMC minutes, or ECB comments which were seen as opening the possibility of an earlier than expected end to asset purchases, the lack of movement in yield spreads which would typically reflect any changes in such expectations of monetary policy shows that these were not the primary causes. The underlying trend of USD weakness has actually been in place since spring 2017, and the latest phase has been running since December. January events have not been the main driver.
Underlying Causes of USD Weakness
Other explanations for USD weakness therefore need to be found. Valuation is the main one that does make sense, as the USD is certainly expensive at current levels from a long term perspective (see chart below)
As the chart shows, the narrow USD effective exchange rate exceeded the high seen in April 2002 in January 2017 when looked at in real terms – that is, adjusted for relative inflation over the period. It was actually the highest level seen since 1986. To that extent, it’s not surprising that the USD peaked out and has been falling for the past year. The real exchange rate – at least its narrow version which relates the USD to developed market currencies – should be expected to be mean reverting, so at this stage the USD remains expensive form a long term perspective. However, this is to be expected when yield spreads are in the USD’s favor. Typically, currencies with relative attractive yields trade above their long term averages and reversion to equilibrium levels is usually dependent on a narrowing of the yield spread.
Lack of Yield Spread Contraction
There are similarities between the current period and the USD’s decline from 2002 after a period of overvaluation around the turn of the century. However, it is different from the USD decline from 2002 in that this time around there has been no real narrowing of yield spreads, while back then the USD reversal was led by yield spreads. By way of an example, the charts below show EUR/USD plotted against the Bund/T-note spread, over the last 3 years and the last 20 years.
As can be seen from the charts above, back in the early 2000s EUR/USD disconnected from yield spreads in the latter part of the USDs rise, helped by the effects of the launch of the euro and the dot-com bubble. Spreads had already moved substantially in the USD’s favor by the time the USD turned in 2002. This time around we are still waiting for a clear turn in long term yield spreads, though they may well have peaked in 2017. This is why, even though the valuation story is clearly against the USD, and in the long run further USD weakness is likely, the pace of the USD decline has been a surprise, particularly in the last few months.
Then USD’s rise into 2017 had been driven by rising US rates and yields and the resultant widening of spreads in favor of the USD. However, the USD’s gains had been extended and amplified by the continued easing of monetary policy elsewhere where the cycle has lagged the US – notably in the Eurozone and Japan – and other factors affecting confidence, in particular Brexit in the UK and various political uncertainties in the Eurozone. While yield spreads have not significantly contracted in the last year, they have stopped widening at the long end of the curve, which has allowed other drivers to have more impact.
Against the underlying background of high USD valuation, the steady improvement in growth and downgrading of political risk in the Eurozone has been a major driver of the EUR/USD recovery. While some political risks still exist, as illustrated by the recent separatist demands in Catalonia, the uncertainty around the German government after the latest election and the potential populist victory in the upcoming Italian elections, political risk in Europe has been downgraded as a risk factor since the election of Macron and the defeat of Le Pen in France last year. Central Banking magazine reported that as late as spring 2017 the biggest worry among reserve managers was the stability of the EUR, and many big sovereign wealth funds had reduced the weighting of the EUR in their reserves as a result. Starting from this position of underweighting no news would have been good news for the EUR, but in practice the news has been generally positive and in the absence of widening yield spreads the flows have favored the EUR recovery. In addition there is a big Eurozone current account surplus which provides a steady demand for euros. In the last few weeks there has not been a great deal of news to affect this situation, but the impact of momentum on FX markets should not be underestimated. Trend followers will now be jumping on the EUR bandwagon in the absence of any reason to reverse direction. The burden of proof is consequently now on the USD bulls.
The EUR has been the dominant leader of the USD decline in the last year but GBP has played a more prominent part in recent weeks. For GBP, Brexit has clearly been the major factor since the referendum in June 2016, but the market is currently prepared to take a more sanguine view of the outlook than it has at any time since the initial vote. It isn’t clear that this is entirely justified by the news, as the negotiation of the trade deal with the EU is still in its early stages and looks likely to be less favorable than the current arrangements. UK growth has also been on the soft side, but in spite of the negatives, the market has been unable to hold on to short GBP positioning given the general USD downtrend, and the unwinding of this positioning has been a big factor in GBP/USD strength in recent weeks.
No Strong Dollar Policy
There have been other factors that have also contributed in January. One is the US administration’s desire for a weaker USD, most recently expressed by Treasury Secretary Mnuchin, though it has been clear since the election that Trump was keen on a more competitive currency. While the desire for a weaker currency is not exclusive to the US and just wanting it doesn’t normally result in weakness without some action, it’s worth noting that the big USD decline in the mid-2000s was helped by the perception that US treasury secretary Snow was not a supporter of the “strong USD policy” established by Rubin in the 1990s. The language of the Trump administration around trade protectionism may also have contributed to USD weakness via reducing the willingness of other sovereigns to invest in the US, but any actual protectionist measures could have the opposite effect of strengthening the USD. Concerns about the NAFTA negotiations have to some extent weighed on the MXN and the CAD this year, though not of late.
The rise in US yields hasn’t led to a widening of spreads in the USD’s favor, but it has led to talk that China was exiting US treasuries, which helped spook the US treasury market in January, but China explained any selling they had been seen to do as “reserve diversification” rather than a loss of appetite for treasuries. Reserve diversification is of course a routine part of China’s reserve management, but if the diversification is more aggressive than usual and represents a deliberate reduction in the USD’s weight in their total reserves, it is a significantly negative factor for the USD.
All this provides some justification for the correction of the USD’s expensive valuation, but we would not overstate the case. The sharp USD decline this year is unusual given the lack of any real narrowing in yield spreads, and we suspect may soon see a correction in part because as the USD weakens monetary tightening expectations in the US will rise and tightening expectations elsewhere will fade. Even though the ECB is expected to end asset purchases this year, no rate hike is expected until 2019 at the earliest, which means there is unlikely to be any spread narrowing in favor of the EUR any time soon. The same goes for the JPY. There are also some significant technical resistances near current levels around 1.25/27 for the EUR and 1.45 for GBP, and for GBP the current sanguine assessment of Brexit may prove short-lived, and domestic UK politics may become a factor with PM May under pressure and potentially facing a leadership challenge. The USD is likely to continue to weaken longer term, especially against the EUR, JPY and MXN where its overvaluation is clearest, but the pace of decline seen in recent months seems likely to slow.
Compliments of Bannockburn Global Forex – a member of the EACC in New York