Towards the end of 2017 and through January 2018 the performance of the US dollar significantly diverged from relative rate spreads developments. From mid-December 2017 until the end of January 2018, US yields rose 14bp relative to other G9 equivalents, whilst the US dollar fell almost 6% over the same period. Such divergent performance, whilst not unprecedented, was certainty unusual.
There was a great deal of debate during January 2018 as to likely causes of the divergence. The prevailing environment was one of strong US and global growth, consensus overweight US dollar positioning, rising bond yields and equity markets, but also rising trade tensions between US and China. The market focused on the possibility that rising trade tensions had prompted reserve managers, notably China, to start to diversify their FX reserves away from the US dollar. This would have explained rising US yields at a time of US dollar underperformance, and also coincided with rising longer-term concerns surrounding the fiscal consequences of tax cuts/spending increases that had just been announced. However, this explanation was subsequently proven to be incorrect as IMF COFER data for Q1 2018 revealed little, if any, selling of US dollar’s form reserves managers. Subsequent data suggested that it was rather private capital and M&A flows away from the US dollar which were responsible for the US dollar and rates divergence.
Over the past few weeks a similar trend of divergent performance between the US dollar and relative rate spreads has occurred. There are also many similarities to market conditions observed now and in January 2018. We believe the current divergence is largely, although not exclusively, positioning driven. Our view is that the US economy will continue to outperform and rates spreads will continue to move in the US dollar’s favour. Therefore once the positioning flush of consensus overweight US dollar positions has been completed we will see some, albeit not complete, US dollar re-convergence to rate spreads.
However, we do also acknowledge that the longer-term outlook for the US dollar remains negative. The US dollar maintains pre-eminent reserve currency status, but we believe that status is being eroded over time. The fiscal outlook for the US is poor and question marks surrounding debt sustainability will inevitably rise the longer the US attempts to run fiscal deficits in excess of 5% of GDP. The increased use of the US financial system to penalise opponents of US policy (e.g. re-imposition of sanctions on Iran and Russia) will also likely serve as accelerant from other major global powers to diversify away from using the US dollar as the major currency in trade and finance. China has a long-term ambition to increase the international use of the Renminbi and EU Commission President Jean-Claude Juncker was explicit in his state of the union speech given this month in increasing the international role of the Euro. The more isolationist approach by the Trump administration is also providing space for other global powers to increase their influence. The announcement that China intends respond to rising trade conflicts with the US by cutting import tariffs from the rest of the world (ex US) is an interesting example of this.
So whilst we believe there remains scope for future short-term US dollar outperformance based on cyclical developments, we are mindful that longer term structural developments will act as a constraint on US dollar performance and ultimately the US dollar is likely to decline sharply if yield support for the US dollar was to reverse.