Where is the US Dollar heading?

 Yvan Berthoux - 03 May 2018

The recent surge in the US Dollar has been haunting investors' minds as to its persistence, especially with the 10-year Treasury bond yield flirting with the 3% psychological threshold. Looking at the US$ index on a daily frequency over the past four years (Figure 1), we observe that the Dollar has broken some interesting technical levels over the past couple of weeks and that the momentum is definitely with the strong US$ story at the moment. It first started by breaking the LT downward trending resistance, then its 100-day moving average, the 50 per cent Fibonacci retracement of the 78.83 – 103.86 range and this week its 200-day moving average, sending the US Dollar index to a 4-month high above 92. In addition, Elliott Wave analysis suggests that the Dollar has entered in a three-wave bull consolidation. In the previous consolidation (marked by the ABC wave), the US$ index rallied by roughly 10pts from 94 to 104. Therefore, that leaves us with the question: has the US$ consolidation just started?

Figure 1: US$ index

Source: Eikon Reuters

Short-term outlook

There are several factors that could explain the current burst of USD strength. First of all, given that the Euro represents a significant weight in the USD index (57.6 per cent), disappointing fundamentals in the Euro area could have reduced the appetite for the Euro in the past couple of weeks. We saw that industrial production in Germany fell from an annual rate of 6.3 per cent to 2.6 per cent in February. Also, GDP growth for the Euro area eased from 2.8 per cent in Q42017 to 2.5 per cent in the first quarter of this year, and the manufacturing PMI declined to 56.2 in April, its lowest print since March 2017. Even though most of the weak data was due to capacity constraints and severe weather conditions, a growing number of market participants have started to price in weaker economic momentum due to growing concerns on the uncertainty over trade wars, Brexit and the ECB exit.
Hence, it can be argued that weaker economic fundamentals underpin the Euro’s 4 figure decline versus USD and may be responsible for the weakness of other major currencies in the FX market (i.e. Cable, Aussie and the Yen). Second, Figure 2 (left frame) shows that the market sentiment on the US Dollar has been extremely bearish in the last few months. According to the CFTC weekly data, the aggregate short speculative positions on the US Dollar reached -242K contracts (US$24bn), its lowest level since 2011, therefore the recent US$ gains may have been exacerbated by some significant short- covering.
Third, a potential breakout of the 10-year Treasury yield above the 3 per cent psychological level could bring back the interest rate (IR) differential as the major driver of FX current cross rates. Over the past 15 months, the relationship between IR spreads and FX spot rates has been completely absent (Figure 2, right frame), however further divergence with the rise of US LT bond yields could bring it back to the benefit to the US Dollar in the short run.

Figure 2

Data Source: CFTC and Eikon Reuters

Long-Term view

Our view on the US fundamental outlook concerning the widening of the US twin deficit is unchanged, and we still think that higher fiscal deficits in the years to come will weigh on the currency. According to the Congressional Budget Office, the US is expected to run US$1trillion-plus deficits in FY 2019 and 2020, an equivalent amount to the years following the Great Financial Crisis (2009 – 2012). Empirically, consecutive years of significant fiscal deficits usually have exerted a negative impact on the US Dollar in the medium term. Each time the US fiscal deficit has peaked, a recession followed shortly afterwards as shown in figure 3. It is hard to believe that the US Dollar could strengthen significantly without having any impact on the US fundamentals. Hence, the recent US Dollar rally may end sooner than some market participants expect.

Figure 3

Data Source: CBO data

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