By Vatsal Srivas
New Delhi, April 16 (IANS): 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.