Has USD Strength Run Out?

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Some analysts, like the chief of currency strategy at Morgan Stanley, are saying that the dollar rally – which started in early 2018 – has come to an end.

At first glance, it isn’t a terribly controversial idea, given the recent understanding that the Fed will moderate its interest raising pace. But there are deeper factors that support this view (as well as some that contradict it), which bear further scrutiny.

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Where We Came From

Last year, the US dollar gained the most in the lead-up to the US-China trade war, as investors sought a safe-haven from market uncertainty. The index gained further starting in mid-October as the stock markets hit their correction, causing capital outflows from financial markets. The index finally turned around in mid-December, right after the Fed meeting.

The points that pushed the dollar higher could give us some insight into what might cause the dollar to go down if those conditions were to reverse. For example, as we’ve gotten positive news from US-China negotiations, the risk-off sentiment that drove investors to the dollar might moderate. However, the really important story is related to the Fed, and has more to do with interest rates and debt (which includes the US’ record deficit).

Carry Trade and Currency Hedging

The US has been, for years, a major source of carry trades, having relatively low interest rates since the last economic crisis. However, the US is also the target of carry trades, particularly from Japan, which still has lower interest rates than the US.

Traditionally the USDJPY has a strong correlation with US treasuries since a major object of investment from Japan are bonds. As treasuries fluctuate, so does the currency pair – and by arbitrage – influences the value of the dollar with other currencies as well.

In normal conditions, when there is an expectation for interest rates to go up, this depresses the value of bonds and increases the price of the dollar (pushing the USDJPY down). But, with the Fed signaling fewer rate increases, the policy from the Trump administration aimed at a weaker dollar to support exports, and the oversized budget deficit that could push up inflation, the cost for hedging USD position has reached 9-year highs.

This has lead analysts from Citi to say that it is no longer profitable for European investors to take positions in US bonds. At the start of 2018, foreigners bought an average of $13 billion a week in US treasuries, but that fell to $9 billion by the end of the year.

Foreign Positions

China is still the largest holder of US Treasuries, despite reducing its holdings throughout the trade war. However, more concern is for the $2 trillion of Treasuries held by Japanese investors who are also starting to unwind due to their position, simply for not being profitable.

Unless interest rates rise high enough to offset hedging costs, investors will find it more profitable to stay away from US bond markets. But the lack of demand from investors could further push bond yields higher as the price of bonds drop.

That Is Another Problem

US companies hold record levels of debt, as a consequence of taking advantage of low interest rates for the last several years. While some of that has gone into capital investment, a substantial amount – and there is no way of knowing for sure how much – has gone into stock buyback programs to push stock prices higher and raise EPS.

Raising yields will put further pressure on companies with high gearing, raising servicing costs and cut into their profits (as well as make it more difficult for them to raise money).

With a record deficit, the US government is in a similar situation; the federal government spend $523B in debt service last year, an increase of over $60B from the prior year (to put that in perspective: over ten times the cost of the wall that has shut down the government).

Add to that the record level of margin in the equities market, the US can ill-afford significant increases in the interest rate – and without the expectation of further rate hikes, the US dollar is not as attractive as other currencies where tightening is also occurring.

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