The Greenback's bounceback

The caricature of the strategist always painting a year of two halves, one bullish and the other bearish or vice versa, is partly true. What’s behind it is the impulse to stay current with macro developments. Timing turning points isn’t easy, but keeping an eye on how things are changing is healthy. We got strong US growth upgrades and higher interest rates lately. This is why the US dollar has strengthened and may continue to do so for some time. Currency moves are mainly driven by trade flows, relative interest rates and risk appetite. Trade flows have to do with the underlying demand for a currency. If domestic interest rates rise relative to foreign ones, speculative capital flows in, leading to exchange rate appreciation. Shifts in risk appetite can overwhelm the fundamentals. When the pandemic first erupted, suddenly the priority was to have cash. And the cash that investors wanted was dollars – it was all about the international dollar and its safe-haven role. This year is more about interest-rate and growth differentials – the domestic dollar and the US economy are in focus.

It’s useful to think about the dollar as two distinct currencies with different drivers:

The international dollar | Safe-haven status: The international dollar has to do with its use as the global reserve currency. It’s inversely correlated with global growth and investor risk appetite, due to the role of US Treasuries as the world’s primary safe-haven asset. Plus, the greenback is also used for global invoicing in world trade and commodities, cross-border lending to emerging markets and central banks’ foreign exchange intervention too. Take the virus outbreak last year. The dollar did strengthen, even though Covid-19 concerns were centred on the US at some point. This simply reflected the currency’s unique role in the global economic and financial system, rather than a view among investors that the US was better placed than other countries to withstand the economic blow.

The domestic dollar | US economy vs rest of the world: The domestic dollar behaves just like any other currency: it strengthens when its macro and market fundamentals outperform those of other countries, and weakens when they underperform. The dollar weakened when the Fed was cutting rates and buying assets more aggressively than other central banks. Of course, a less favourable interest-rate differential and a significant increase in dollar availability were two negatives for the greenback. What’s happening now is that US Treasury yields are rising more than Bund yields. Bond yields, in turn, are responding differently as growth expectations are getting upgraded for the US and downgraded for the euro area. The dollar is reacting by moving higher versus the euro.

Here’s why this matters:

Dollar strength ahead: We don’t believe that the dollar is likely to appreciate rapidly and against all currencies at the same time. Rising oil prices have pushed up the currencies of oil producers such as Canada and Norway, and sterling has recovered a great deal – though the path looks more sideways from here. We think the dollar is likely to strengthen mostly versus the euro (and perhaps other low yielders) as the region’s reopening seems more uncertain and its economic underperformance starker. The key domestic macro drivers – rather than safe-haven flows – should now become more important as differentiating factors for currencies. At the same time, judging by the choppiness of some equity markets, risk appetite looks less ‘greedy’ than it was – another factor that may support the dollar, as investors could perceive it as the least-worst place if they chose to sit out the volatility.

The euro side of the story: We no longer expect the dollar to weaken versus the euro. We now see the current level of just under 1.20 as a likely turning point and project gradual dollar strength from here. This is because we now see stronger growth and higher inflation in the US relative to the euro area, and more scope for rising Treasury yields versus Bund yields. The Federal Reserve looks relatively comfortable with rising yields as long as it’s because of strong growth, and the upcoming inflation spike is temporary. The European Central Bank seems wary of any unwarranted tightening in financial conditions and has recently stepped up the pace of its bond purchases to mitigate the rise in yields. Extra fiscal stimulus in the US and faster vaccine rollouts contrast with a slow implementation of the EU recovery fund and a lagging inoculation programme in most euro area countries.

Meanwhile, let’s look at what’s going on this week…

US set to rebound: While vaccine rollouts in the US and UK (with some announced logistical challenge next month) are ramping up, safety concerns in Europe are likely to further delay the timeline to lift the restrictions and reach heard immunity, which is further complicated by an increase in new cases recently. On the data front, the highlight is March’s purchasing managers’ indices. In the US, some states have started to lift restrictions given the continued fast rollout of vaccines, perhaps supporting business optimism, as suggested by the Philly Fed manufacturing survey printing the highest reading in nearly 50 years – we expect strong growth. In Europe, lockdowns have been extended in some countries (France, Italy) and the UK is moving towards reopening rather cautiously, potentially indicating still weak activity in services in both.

Daniele Antonucci | Chief Economist & Macro Strategist