Round numbers have psychological resonance. The US dollar index is trading at its highest level since mid-January, in part because of interest rate support. US 10-year Treasury yields have risen close to the psychological 3% barrier, last reached at the end of the Taper Tantrum in early 2014. And the yield gap between two-year US and German bond yields breached its 3% barrier last Friday, the widest gap since 1990.
But, while interest rate differentials may lend short-term support to the USD, we see reasons for the US currency to resume its slide over the medium term:
- Round numbers have little economic significance. From an economic perspective, US rates at 3% are little different from 2.9% or 3.1%, and we believe the bulk of the rise in 10-year yields for this cycle has already occurred. With yields unlikely to move much higher in our view, their ability to drive further USD gains is likely to fade.
- The US current account deficit and growing fiscal deficit will need financing. Fiscally stimulating an economy at full employment is likely to suck in imports, widening the trade deficit and exacerbating the problem. For example, the gap between the US and Eurozone current account deficits has now widened to seven percentage points of GDP – near the highest level in more than a decade. The need to attract capital is one reason why yields have risen and could also require a cheaper dollar.
- On the capital account, because of persistent current account deficits, US external indebtedness is rising rapidly. Net US liabilities are now more than 40% of GDP, a record. To help stabilize the position, USD depreciation is needed over the medium term.
Overall we look for further USD weakness in the medium term. We prefer the euro to the USD and forecast EURUSD at 1.30 over 12 months.
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