Dollar’s recent weakness — Blip, not new trend

In the past nine weeks major currencies and global equity markets have traded broadly in line with our expectations.

The US Dollar has traded in a very narrow range, confounding consistently bearish market expectations. Similarly, most emerging Asian currencies have barely moved, pointing to the ability and willingness of Asian central bank to intervene in FX markets in a bid to manage both the volatility and directionality of their currencies. Conversely, emerging currencies, particularly in Latin America, have been prone to sharp pull-backs.

Stretched currency valuations and still very weak global economic growth in January — which tallies with our forecast — has likely been a driver of currencies’ performance.

In the past five weeks the inverse correlation between the Dollar and S&P 500 and between the Dollar and the steepness of the US Treasury yield curve has broken down.

Our take is that the broad-based diversification out of Dollars, driven by buoyant global risk appetite and market concerns about the Dollar’s real carry, has stalled and slightly reversed. We suspect that central banks and sovereign wealth funds may have re-focussed on domestic factors, which has in turn led to a rotation between other reserve currencies.

This includes a rotation out of Euros and move into Sterling and a rotation out of the safe haven Swiss Franc and in particular Japanese Yen into commodity reserve currencies — namely the Canadian and Australian Dollars and Norwegian Krone — and New Zealand Dollar. These four currencies’ NEERs are now near the top end of their three-month ranges. In each case specific drivers have been in play, in our view. Our analysis suggests that the Norwegian Krone may still be “cheap” relative to the current price of Brent crude oil.

Figure 8 suggests that a rotation in and out of other (EM) currencies which were 1–2 months ago trading at the extremes of their ranges may have also taken place.

The Dollar NEER has weakened about 0.9% since 4th February and its inverse correlation with the S&P 500 (+1.2%) has re-established itself. We think this is a short-term correction, with another prolonged Dollar downtrend still a couple of months away.

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