Abheek Barua*
As expected the US Federal Reserve increased the policy rate by 25 bps day before and kept its future policy rate path unchanged – with one more hike in December 2018 and three more in 2019. Fed’s policy action was already priced in and therefore did little to significantly push up the dollar index. However, comments by the Fed chair yesterday that the US does not face a large chance of recession and the Fed plans to keep gradually increasing rates raised the dollar index above the 95 level today.
The Fed did not comment on the dollar’s value – which barring the last few weeks has had a good run this year. The dollar as measured by the DXY has rallied by over 6% since February, driven by strong US growth (at 4% in the second quarter), the safe haven trade and high interest rate differentials. This has led to the view that the dollar is overvalued and a correction is in the offing.
In our opinion, when and how the dollar rally turns is likely to be an important factor in driving currency markets over the coming months. To put this in perspective, the movement in the dollar index could be an important determinant of the trajectory of EM currencies, like the INR, over the next 6-8 months. So where is the dollar headed?
We think that while in the near term dollar strength is unlikely to abate significantly, we could see the dollar rally reverse as we get closer to 2019. However, the bulk of the correction in the dollar could (going by current trends) come against the DM currencies such as the Euro and the GBP and less against the emerging markets. While we are more sanguine about the gain in DM currencies against the dollar, the extent of the recovery in the EMs remains uncertain. Some EM currencies have fallen sharply in recent months and as a pack are undervalued. This warrants some appreciation against the dollar. However, given the continued rotation of funds away from the EMs, the extent of the recovery in EM currencies remains unclear.
Short Term strength in the dollar could continue
Net long positions on the dollar are high: Our short term view of enduring USD strength is supported by the record high net long positions on the dollar.
Hedge funds boosted their bullish bets on the dollar to the highest level since late 2015 in August 2018. Since then, long positions on the dollar declined slightly as trade war related tariff increases were being considered less severe than expected, therefore curbing safe haven trade in September and in turn leading to some moderation in the dollar index (close to 3% decline since mid-August). That said, the imminent US Fed rate hike and strong labour market data have supported the dollar in recent days. Latest data shows that net long positions among leveraged funds rose to $22.98 billion in the week to September 18 (from $19.16 billion in the previous week), according to the US Commodity Futures Trading Commission. Overall, given that speculators have been net long dollars for 14 straight weeks, the sentiment towards the dollar remains bullish. This implies two things:
- First, an imminent (significant) correction in the dollar is unlikely.
- That said, the large long position restricts the room for further longs on the dollar. This in turn means that the room for further appreciation in the dollar is also limited. Therefore, we think the dollar index could trade in the range of 94.00-95.50 in the near
Safe haven trade: The USD has benefitted in ‘risk-off ‘episodes and remains the principal safe haven currency. We anticipate an escalation in the ‘risk-off’ sentiment if:
1. President Trump continues to pressurise China with further tariffs (most recently announcing tariffs on $200bn of China’s exports) the safe haven trade will be supportive for the dollar in the short term.
2. US sanctions on Iranian Oil raises oil prices: The impending US sanctions on Iran, due to be implemented in November, could keep oil prices firm, escalating risk off trade.
In the short term (1-2 months), all these could be dollar positive in periods of risk off trade.
When could the pro-USD trade turn?
The next game changer for the dollar could be the Mid-term elections on 6 November. The democrats need 23 seats in the house of representatives and 2 seats in the senate to gain majorities in the two houses of the US Congress and impede or slow down the Trump agenda and force some degree of fiscal consolidation. If the democrats are successful in doing so, it will raise questions over the extent of continued fiscal easing in the US and could be the inflexion point for the dollar.
However even in the absence of a change in the political and policy-making environment there could be some risks that could lead to a change in the direction of the dollar:
- ‘Overvaluation’ signals impending correction: Firstly, the dollar is clearly overvalued and more appreciation could start impinging on US growth adversely affecting exports. More importantly it could encourage imports, working directly against the ‘’Make in the US ‘agenda. Conventional measures such as the REER suggest an overvaluation of close to 10% according to IMF data and close to 15% as per the BIS REER measure, as of July 2018. Also, a simple technical analysis of Bollinger bands (calculated by using standard deviations) shows that the dollar is clearly close to the upper bound of the bands – which signals overvaluation.
Dollar remains overvalued
- US growth to slow down: The US is currently gaining from fiscal expansion and relatively benign interest rates. However, some changes could play out going forward. First, there are tentative signs of wage pressures slowly building up that could keep the Fed on the rate hike track. Second despite somewhat overt pressures from the White House, the Fed does not seem keen on adventurism and is unlikely to support expansionary fiscal policy by loosening its monetary grip. Finally, a full blown trade war could push costs up and lead to supply disruptions, causing both cost-push inflation and whittling down firm competitiveness. Thus it is very likely the US growth is likely to slow down in 2019 as the impact of trade war filters in and monetary policy continues to tighten.
- Interest rate differential narrows: As the ECB comes to the end of its ultra-loose monetary policy and the Fed moves closer to its neutral rate, global interest rates will start to converge and the dollar could start to decline.
- Talking down the dollar: As we have mentioned earlier, a strong dollar works against President Trump’s agenda of nurturing domestic industry. Trump has made it clear through his recent comments that he does not support a strong U.S. dollar and once headline growth or export data start to disappoint, his efforts to talk the USD down could amplify.
- Worries over the twin deficits return: The U.S. economy is running a sizeable current-account deficit, which needs the dollar to weaken to rebalance. Moreover, as the markets shift focus towards the worsening current and fiscal balance in the US, the dollar could lose its shine. Historically the US fiscal deficit and the dollar index have had an inverse relationship with periods of high fiscal deficit coinciding with a lower dollar index. Drawing from this relationship, we can expect the dollar to feel some pressure as the fiscal deficit continues to rise this year and the next. Given the tax cuts and increased government spending (higher spending under appropriations bill, subsidies under the Affordable Care Act etc.), US fiscal deficit as a percent of GDP is expected to rise to 3.9% in 2018 and 4.6% in 2019 as per the Congressional Budget Office’s latest projections.
US fiscal balance and dollar index – An inverse relationship
- The Oil effect – lower consumption versus higher production: Unlike in the past where in oil prices and US growth had a negative relationship, the dynamics between these two variables has changed in recent years.
a. Now, higher oil prices exert two opposing forces on US growth. The first more conventional pressure is that higher oil prices hurt consumers and in turn can have a moderating impact on overall growth. On the other hand, with the US also becoming a major oil producer (US crude production has more than doubled from an average of 5 million barrels per day in 2008 to 10.3 million bpd in February 2018), higher oil prices also boost economic activity and investment.
b. The net impact depends on the level of oil price where in, one of the effects outweighs the other.
c. So far, higher oil prices have had a net positive impact on US growth – oil and gas related investments accounted for 40% of the growth in business investment in the April-June quarter this year.
d. That said, a sharp increase in oil prices – with impending US sanctions on Iran – could tip the scales unfavourably for overall US growth.
Dollar movement against DMs and EMs
We reiterate that we could see two faces of the dollar going into 2019. The dollar could depreciate significantly more against the Developed Markets (DMs) than against the EMs. While we are more sanguine about the gain in DM currencies against the dollar, the extent of the recovery in the EMs remains uncertain.
- The DM story: We see growth in Europe and UK picking up pace as we go into 2019 while slowing down in the US. The ECB is likely to unwind its stimulus program by the end of this year (reduction in bond purchases from 30bn euros to 15bn euros in last three months of 2018 and end of bond purchases thereafter) and the markets are expecting a rate increase in the latter half of 2019. On the other hand, the Fed is likely to raise rates two more times this year and 2-3 times next year, reaching the end of its rate hike cycle as the interest rate moves close to the neutral rate. If we were to filter out the ‘shock factors’ like the trade spat or the unexpected jettisoning of the Iran agreement, these rate increases are substantially priced into the dollar. All these constitute a case for an appreciation in the DM currencies such as the EUR and the GBP against the dollar in the medium term.
- Extent of EM recovery remains unclear:
o EM pack undervalued, warrants some appreciation against the dollar: EM currencies are undervalued based on the BIS REER measure with the exception of export oriented currencies such as the THB and the KRW. Others such as the IDR, the RUB, and the BRL are trading at levels that are undervalued anywhere between 11%-20% as of July 2018. The INR which was more or less close to its fair value in July (level of 68-69) would now be undervalued by close to 2-3% according to the BIS measurement. Given this, there could be some appreciation against the dollar and move towards the fair value in most of the EM pack over the next 6-8 months. The recovery could be more in currencies such as the IDR, RUB, MYR, and INR as compared to the EM exporters such as the THB and the KRW that remain overvalued.
o EM central bank policy measures could also provide support: Some EM central banks such as Turkey, Argentina, and Indonesia have already increased their interest rates in order to restrict the fall in their currencies as well as to reign in domestic inflationary pressures. Others such as South Africa are keeping interest rates firm, despite low inflation and weak growth, to protect the ZAR. A continuation of tighter monetary policy across the EMs could help provide some support for the EM currencies. Although, we remain sceptical about the effectiveness of these measures as a medium term support for the EM currencies as developed market interest rates also continue to rise.
o However, EM risks remain and these could limit the extent of appreciation in the EM currencies against the dollar: While EM currencies could recover against the dollar, we think that the recovery could be shallow. The upside to the EM currencies could be capped due to these following factors:
a. The markets could remain worried about how EMs that have a high current account deficit and external debt would finance this in a tightening global scenario.
b. Financing would become a challenge as the rotation of funds out of the EMs could keep the pressure on the whole EM pack. As ECB joins the Fed in pulling back its easy monetary policy, global liquidity could tighten, leading to a continued outflow of funds from the EMs. (As per IMF estimates, around USD 260 bn in portfolio flows in the EMs since 2010 can be attributed to the unconventional monetary easing policies of the Federal Reserve. Out of this around USD 70 bn could go back).
c. Rising global protectionism could maintain the pressure on the EM exporters. The US-China trade war and the slowdown in growth in China could hurt EM exporters such as the THB and the KRW.
d. Therefore, we expect that although the rupee could see some respite and reverse from current levels, the recovery could be capped. The USD/INR pair could settle in the range of 69-70 against the USD over a one-year period.
Treasury Economic Research team
Disclaimer: This document has been prepared for your information only and does not constitute any offer/commitment to transact. Such an offer would be subject to contractual confirmations, satisfactory documentation and prevailing market conditions. Reasonable care has been taken to prepare this document. HDFC Bank and its employees do not accept any responsibility for action taken on the basis of this document
*Mr. Abheek Barua, Chief Economist, HDFC Bank. Mr. Barua tweets at @AbheekHDFCBank.
Sir, Please let me know the AUD-USD pair behaviour
in next one to three years..will AUD appreciate against USD in a year or two