Market Analysis: Upcoming US dollar strength could be short-lived
The US dollar has been a topic of detailed discussion at Neuberger Berman.
Longer term, we believe the dollar is close to fair value, if not slightly overvalued, and on a downward trend. That view is supported by the exchange rates implied by purchasing power parity and the negative sentiment associated with the US’ twin deficits, caused by an aggressive fiscal expansion that will demand foreign financing.
Nonetheless, we have a cautiously positive near-term dollar outlook. This reflects the view that the long-term bearish dynamics described above, in combination with changes to central bank balance sheets and perceived US political risk, have pushed the currency too low already.
The dollar also enjoys support from US interest rate divergence with the rest of the world. Dollar selling, both speculative and related to unhedged flows into European equity markets and hedged flows from European and Japanese investors into US fixed income, has persisted despite the fact that interest rate differentials have widened dramatically in favour of the US currency, up to around 3 per cent per year.
When an investor hedges the foreign-currency exposure of a non-domestic asset, it effectively sells the foreign currency to buy its domestic currency. Current interest rate differentials mean that a euro or yen-based investor hedging US dollar exposure is selling a currency that earns around 3 per cent per year more than the currency it is buying.
Over recent years, many investors have looked to international markets in their search for higher fixed income yields. The US, where interest rates have been rising before those of many other major developed economies, has been one of the more obvious places to go. Those investors will usually hedge the foreign-currency exposure from fixed income assets, but they rarely take the costs of hedging into account when they are comparing yields because in most cases the difference it makes is small.
It does seem likely that euro and Japanese yen-based investors will begin to question holding currency-hedged US assets now that hedging costs have reached 3 per cent per year, however. By the same token, US dollar-based investors will eventually notice that they can earn 3 per cent per year simply by hedging the euro exposure they get through their European assets back to dollars. Moreover, we expect that 3 per cent, known as the “carry” between the two currencies, to rise as we see further divergence in monetary policies.
The incentive to reverse recent flows out of the dollar are building, therefore. Signs of growing demand for US dollars have been appearing – the recent rise in the US dollar overnight index swap rate is one example.
At the same time, we think the euro is overvalued, on a short-term view: it is making financial conditions in the euro zone too tight and does not reflect the fact that European inflation remains subdued, that Purchasing Managers Indexes and other economic data have moderated over recent months, or that the region’s political risk remains elevated.
Because our strong-dollar view applies only to the short term, within a longer-term downward trend, Neuberger Berman’s asset allocation committee (AAC) maintains its cautiously positive view on assets that have been sensitive to a strengthening dollar in the past, such as emerging market bonds, currencies and equities. As well as acknowledging that global investors are still under-exposed to emerging markets and that they are much earlier into their recovery than the developed markets, the AAC regards the long-term downtrend in the dollar as a net-positive for the emerging world.
Recent signs of a comeback for the greenback probably should not give reassurance to long-term dollar bulls, in our view. There are technical reasons for a reversal of the downward trend that has been in place since the start of 2017 – but they are likely to prove temporary.
This rally may offer some more attractive levels at which to establish dollar shorts or underweights.
Ugo Lancioni is Global Head of Currency at Neuberger Berman, which is a member of The Gulf Capital Market Association.