The US dollar has performed poorly so far this year, falling about 6% on a trade-weighted basis. Investors were wrong-footed early in 2017, when they bet that US tax reform would push the dollar beyond already lofty valuation levels and help the American economy continue to outperform the rest of the world. Those hopes were dashed when it became obvious that the Republican Party did not hold uniform views on how Obama-care and tax policy should be reformed, coupled with a series of underwhelming inflation figures. Meanwhile growth in the rest of the global economy continued to strengthen, and victory by Macron in the French presidential election made the Eurozone investible again against a background of likely European Central Bank tapering in 2018.
Yet in recent weeks the dollar appears to have found its feet again, rebounding by about 3% on a trade-weighted basis since early September. The market has become increasingly confident that some elements of US tax reform will be achievable in the months ahead. The recent outperformance of companies with high effective taxation rates versus index averages signals that something concrete on tax is starting to be discounted by investors. However, such relative performance could still extend significantly further before December 2016 levels are revisited. The US dollar can keep rallying if investors believe more business friendly tax changes and corporate tax cuts are indeed going to materialise, and if prospects for fiscal stimulus lead to the FOMC delivering on their median dot projections despite relatively low historic rates of inflation.
So against which currencies should investors hold dollar overweight positions? Investors could be forgiven for thinking it’s clearly the euro, given its stellar performance year-to-date. But that would be a mistake. There is up to an estimated €1tn of quantitative easing related outflows that could still return to euro denominated markets and the IMF COFER data from late last month highlighted that central banks still held a significant underweight to the euro in their FX reserves as of the end of the second quarter (19.9% of allocated reserves compared to a pre-Eurozone crisis average of closer to 25%). Normalisation of these flows/exposures should provide support for the euro, possibly preventing the US dollar appreciation against the single currency, and ensuring it’s not the best way of expressing a bullish view on the dollar.
What to do in an environment where both the dollar and euro appear attractive, albeit for different reasons? Those convinced of the long-term upside for the US dollar would do best to hold that position against currencies where central bank policy is more stable, despite the sudden acceleration of global growth. The Japanese yen fits that bill nicely. The Bank of Japan remains firmly committed to its yield curve control framework, and its policy of targeting 10-year Japanese government bond yields close to 0% serves to reinforce monetary policy divergence in an environment of rising US Treasury yields. It is also possible that as the FOMC hikes rates and US Treasury yields and hedging costs rise, Japanese insurers indicate that future investment plans include unhedged US bonds, providing the yen with a further boost.
Emerging market currencies have performed strongly this year, boosted by the tailwinds of strong global growth, improving fundamentals and the appetite by investors for high yielding assets. However, emerging market currencies have struggled in recent weeks as investors face new headwinds in the form of rising Treasury yields. Investors who want to remain overweight emerging market currencies would benefit from diversifying their funding base towards other developed market currencies, to mitigate the impact of a potentially resurgent US dollar.
Much of the medium term outlook for the US dollar hinges on the delivery of tax reform legislation, given its potential to lift economic growth and corporate earnings. If tax reform momentum can be sustained over the balance of this year and into next, further gains are likely for the dollar. In this scenario, investors should benefit from holding overweight US dollar positions; bearing in mind the greenback will likely make the greatest gains against currencies most vulnerable to higher bond yields.