UBS Intellectual Capital The Dollar Decline – Done or Delayed?


25 Aug 2017

Mark Haefele, Global Chief Investment Officer at UBS Wealth Management

The US dollar has fallen a long way since its weighted value against other currencies reached a 14-year high last December. From its peak, the currency has depreciated by around 9% on a trade-weighted basis amid fading expectations of fiscal stimulus from the Trump administration, weak inflation data, and more dovish rhetoric from the Federal Reserve.

Furthermore, over the longer term, the greenback likely remains vulnerable. The country’s low savings rate and correspondingly high current account deficit mean that the US needs to attract $2.9 billion each day just to keep the dollar stable.

If Donald Trump adopts a protectionist stance, this could be another risk: when George W Bush in 2001–2002 used tariffs on foreign steel, the dollar sold off in fear of retaliatory measures from other trading blocs. And despite its losses this year, the dollar remains overvalued on a purchasing power parity (PPP) basis by an estimated 42% versus the yen, 17% versus sterling, and 6% versus the euro.

But, in the near term, the market might be underestimating the potential support for the US currency.

First, expectations for further rate hikes by the Federal Reserve are too low. The market is pricing in only one further rate hike this year, with a 32% chance of a rate rise in December.

Given that US inflation has been weaker than expected for five consecutive months, this pricing might appear reasonable. But last week’s retail sales figures rebounded to an annualized growth rate of 4.2%, pointing to robust consumer spending; and the number of first-time jobless claims fell to its lowest level since February, highlighting further tightening in the labor market.

There is potential for dollar strength if the Fed signals a willingness to speed up normalization of monetary policy. If the Fed sets a start date for shrinking its balance sheet at September’s Federal Open Market Committee (FOMC) meeting, for example, there could be support for the dollar.

Second, the market appears to be pricing in a virtually zero chance of fiscal stimulus being passed. Shares of small US companies, which are domestically focused and thus have more to gain from tax reform, have given up virtually all their post-election returns in excess of large company shares. Shares of large companies that pay high tax rates have also given back all of their post-election gains.

Consensus forecasts for US gross domestic product (GDP) growth are also relatively flat – 2.1% for 2017, 2.3% for 2018 and 2.1% for 2019 – suggesting low expectations among market participants for a boost to growth from fiscal stimulus. While the probability of a fiscal stimulus package being passed most likely has fallen, expectations are so low that the dollar could stage a rebound if there is progress on a tax reform package, or if the debt ceiling is successfully raised without incident. Finally, according to data from the Commodity Futures Trading Commission (CFTC), net short positions against the US dollar are at their highest in over four years.

Overall, though the dollar likely remains vulnerable, the risks of selling it and hoping for it to fall further have increased in the near term.