Call for dollar bull-run premature

By:
Peter Garnham
Published on:

The potential for the Federal Reserve to exit its ultra-loose policy stance has led some to believe that 2013 is the year the dollar will stage a rally and break free from the bear market that has pressured the currency for more than 10 years – but those calls are likely to be premature.

The prospect that the Fed might be considering an exit strategy from its quantitative easing (QE) programme during the next two years comes at a time when most other central banks are considering steps to further increase monetary accommodation.

Comments from Fed officials over a potential exit have therefore been seized upon as a sign that the market might now be witnessing the start of a period in which the dollar begins to rally on good news from the US economy, a stark contrast to the periodic bursts of strength seen in the past five years.

Since the financial crisis, the dollar has experienced a number of periods of sustained strength. Those have all, however, come as a result of episodes of heightened risk aversion. Rising fears over the global financial system have boosted the dollar, as risky positions funded in the currency have been cut and US investors have repatriated funds from higher-growth markets.

While those periods of dollar strength have been violent, they have all been quashed by official action to restore calm in financial markets.

It has, in other words, been some time since the dollar has rallied on the back of better news on US activity, inflows into US equities or a rise in US yields.

Indeed, the dollar has been in a broad downtrend for 11 years, exceeding the previous bear market in the currency from 1985 to 1995 that occurred in the wake of the Plaza Accord.

 Dollar bear market started in 2002; now longer than post Plaza Accord decline
 

Aditya Bagaria, FX strategist at Credit Suisse, says the historical comparison with the length of the dollar’s last bear market adds to the temptation to begin looking for evidence of a sustained, broad recovery in the currency this year.

He says, however, that the low levels of US yields at the moment argue against a broad dollar recovery.

As can be seen from the chart below, the last two troughs in the dollar have roughly coincided with a break higher in US front-end yields above the average three-month yields of the rest of the G10 economies.

 Dollar to remain a low-yielding currency through to the end of 2014
 

Bagaria says this suggests the dollar needs some yield premium to be a strong currency, or at least it cannot rally for long when it is a low-yielder.

“The intuition behind this would be that, as a current account deficit-backed currency, the dollar needs demand from yield-seeking investors to have its clearing price rise, and the currency is vulnerable to hedging activity and carry trade funding when it is at a yield disadvantage,” he says.

“In the absence of yield, the US is forced to rely on passive financing from emerging market central banks, managing their own currency rates by absorbing excess dollars, but not providing an active boost for the dollar versus other G10 currencies.”

The dollar remains fairly deep in low-yield territory now, and futures pricing suggests little scope for improvement through to the end 2014.

As Bagaria notes, to anticipate a yield-driven recovery in the dollar, an investor would need to argue that futures markets are now substantially underpricing the scope for Fed tightening, or are underpricing the risks of policy easing in the rest of the G10 economies.

However, history suggests that Fed tightening alone is not sufficient to halt a bear market in the dollar. The dollar continued to fall in 1994 and 2004, even after the Fed began tightening monetary policy, only stabilizing once US rates reached a premium over the rest of the G10.

“Indeed, on average, we have found that the dollar has a strong tendency to weaken in the initial months following the start of a Fed rate hike cycle,” says Bagaria.

Leaving aside the evidence that suggests the dollar will not rally, even if the Fed announces its intention to exit from its easing policy in two years’ time, there is reason to suppose that the central bank will leave liquidity taps open for longer in any case.

While the US Congress avoided the fiscal cliff at the start of the year, sequestered spending cuts of $85 billion could still go ahead this year, and up to $1.2 trillion of cuts during the next nine years.

The US Congressional Budget Office estimates the cuts could cost 0.6 of a percentage point of GDP growth in 2013.

Should that occur, the Fed is likely to be forced to increase its QE plans, irrespective of the desire of some regional presidents on its Federal Open Market Committee to reign in asset purchases.

For the time being, the prospects of a growth-led rally in the dollar would seem remote.