FX: Too early to call the top on the dollar rally?

What led to dollar strength?

If dollar strength has been the single defining trend of the past 12 months, there are many factors that have contributed to this. Understanding these reasons will help us determine whether we can expect the dollar to rally further in 2019 or whether its bull run is ending.

The economy, stupid

Without question we have seen a significant degree of outperformance in the US economy, which underpinned dollar strength on core fundamentals. US exceptionalism, an idea that has flourished under Trump, was undoubtedly on show last year, in pure economic terms at least.

Unemployment has fallen to 50-year lows and in many ways the US labour market has not looked in better shape. On an annual basis, gross domestic product (GDP) expansion accelerated to more than 4 per cent in the middle of the year, far ahead of other developed economies. Growth differentials were key to the dollar ascent, but 2019 could be a different story for one major reason: fiscal stimulus.

Tax cuts enacted by Donald Trump were central to this economic boom, although there is some debate as to the extent to which the halo effect will start to diminish after the first year. Some see the tax cuts as essential to longer-term economic health, others view them as nothing more than a short-lived sugar rush designed to boost approval ratings and market sentiment. Next year is when we get the answer to this question.

The Fed

Faced with an upswing in economic activity and a labour market that was its tightest in 50 years, the Federal Reserve (Fed) was left with little option but to raise rates each quarter in a series of steps that lifted the front end of the curve and bolstered decades-wide spreads with German bunds. Given the spread between 10-year US Treasury bills and bunds, you would be forgiven for thinking the dollar should have rallied more. This can be explained by the jump in Treasury issuance to fund tax cuts, the Fed reducing its balance sheet and significant dollar hedging costs. The last of these meant it was not a simple matter of swapping euros for dollars to take advantage of higher yield US Treasury notes. In fact, hedging costs means it’s been more lucrative to sell dollars to buy even ultra-low yield European debt.

Generally, rising US yields have boosted the dollar, but we are not sure to what extent this will continue through 2019. 

Trade

Trump’s economic policy involves domestic tax cuts and aggression against foreign powers, a combination that has juiced the US dollar. In particular the ‘Tariff Man’ has helped fuel a stronger dollar with his approach to trade. To reduce it to a very simple explanation, tariffs and a contraction in global trade have forced up the greenback by making dollars scarcer. Fears about the impact of a trade war on emerging markets and China also drove a flight to safety, with the dollar the chief haven given US economic strength generally. In addition, repatriation of corporate profits by US companies helped fuel dollar strength.

Will these factors persist in 2019?

It’s certainly difficult to see the party continuing in quite the same way for the US economy. But with the outlook for Europe and the global economy also looking murkier, that does not in itself mean the wheels will come off the dollar bandwagon just yet. In fact, we may well see further dollar strength play out through the first half of 2019 and beyond even as yields retreat and growth cools.

Yields have already started to moderate, and we have even witnessed the yield curve invert – when the short end yields more than the longer end. This is seen as a major red warning signal for a looming recession, as it indicates markets are anticipating that the Fed will start cutting rates.

In terms of US growth, the heady 4 per cent level is not expected to continue through 2019, with a reversion to the 2 per cent level expected by economists and the market. High-frequency economic data have started to soften, and the stimulatory effects of tax cuts will phase out.

A widening budget deficit – spurred on by the unfunded tax cuts – is also seen as exerting a bearish drag on the US dollar. Slower growth will make it harder to service the twin budget and current account deficits, exposing the dollar to further risks. 

Meanwhile, the Fed is expected to be more cautious on rates. Chair Jerome Powell notably walked back his comments lately, noting that US interest rates were currently “just below” neutral, barely two months after he said interest rates were “a long way” from neutral. The market had bought into the notion that the Fed was going to keep on hiking, but his subsequent remarks signalled the Fed is much closer to ending the tightening cycle.

Finally, tariffs are coming back to bite. While the threat of a trade war helped fuel dollar strength, as the impact is felt we would expect the US economy to take a hit, with rising input costs creating a spiral of bad inflation that ultimately, if combined with a major deterioration in the economy as a result of a Fed policy ‘mistake’, could lead the US economy into a period of stagflation. 

But does all this mean we see a weaker dollar? Maybe not. While the macroeconomic picture in the US is softening a touch and forcing a slightly more dovish view from rate setters than maybe the market had thought, the outlook in the rest of the world is not much better. The argument is that while the US – and therefore the dollar – outperformed in 2018, the world’s largest economy will fall into line with other countries in 2019. 

This would be dollar negative, although this does not mean the dollar rally will stop yet. Indeed, we could well see the dollar index hit the 100 level before 2019 is over. Crucially it seems like eurozone monetary policy anchoring and disappointment will act to stem any major dollar decline thereafter. Moreover, any further slowing in the global economic picture may result in more emerging market stress and produce more of the kind of flight to quality we witnessed in 2018. 

And while the Fed chair has sought to calm markets with softer language around the neutral rate, markets may be misjudging the Fed. The softening in yields from their 52-week highs may be overdone. It seems likely that it will hike at least twice in 2019, and this will keep the upward pressure on yields in support of the dollar.

ECB anchored

As far the euro goes, we are looking at this through the prism of monetary policy. The European Central Bank (ECB) looks increasingly cornered. While quantitative easing (QE) is ending this month, there is little to persuade us that the central bank will be able to raise rates as quickly as the market has been expecting.

Mario Draghi and co have been sticking resolutely to their inflation expectations despite the signs that indicate that convergence with target will be slower than forecast. As the QE punch bowl is removed and global economic risks mount, it’s hard to see how inflation can track the trajectory the ECB expects. Even its own staff projections show the ECB does not see inflation reaching its target of 2 per cent by 2020. 

Meanwhile market inflation expectations have cratered. So-called market-based gauges of inflation expectations sank to their lowest level in a year in November. The swaps market indicates an average inflation rate of around 1.65 per cent over the next five years, significantly below the ECB’s 2 per cent target. 

Meanwhile growth has materially slowed. Eurozone growth rapidly decelerated in the third quarter, with GDP rising just 0.2 per cent in the three months to the end of June. This was the slowest pace of growth since 2014, before the QE programme began. Indeed, since the ECB began buying bonds, inflation and growth have failed to gain a self-sustaining momentum that suggests they will improve without more monetary stimulus.

Moreover, risks seem skewed to the downside, with trade concerns a big worry. The heady pace of growth in Q4 2017 is now a distant memory and without the necessary structural reforms that Mr Draghi has been demanding since before he even took up the helm at the ECB, there seems little chance of a sudden improvement for Europe if the global economy doesn’t pick up. Its fortunes are very much tied to the rest of the world, unlike the US, which relies on far more domestic demand.

There is a material risk that the ECB ends up in a position where it stops buying bonds in December entirely as planned, but has to then loosen policy again in 2019 when inflation still fails to come through, or there is a global downturn that threatens growth. There is a strong chance that the ECB is left in a position of negative rates ad infinitum, or worse yet it is forced into hiking prematurely, leading to recession.

As Mr Draghi has noted, the inflation increases of late have largely reflected mainly higher food prices and energy inflation, while annual inflation is set to hover around the current level for the coming months. Domestic cost pressures are strengthening and broadening due to tight labour markets as well as negotiated wage hikes, he says, but it’s hard not to think that headline inflation will soften in the wake of the rapid and lasting decline in oil prices. Indeed, Mr Draghi has recently noted that incoming information was somewhat weaker than expected.

Another vital question for the euro is this – does the ECB consider core or headline inflation more important? That is still not entirely clear and leaves a degree of ambiguity around the inflation target and convergence process. This is an ambiguity that the ECB needs to acknowledge and resolve sooner rather than later.

Data is weaker – but to date not enough to really change how the ECB views the balance of risks. The question is: how long before it does tilt the balance? There is mounting evidence to suggest the ECB is closer to taking its foot off the tightening pedal than it is to pressing down harder, which should suggest further euro weakness to come. Moreover, ongoing political uncertainty in Italy would appear to act as a headwind for the euro.