The US dollar has been, and continues to be strong, against a bevy of EM currencies but has been weaker against the Japanese Yen, and had only moderate successes versus the Swiss Franc, the euro and against some currencies from Eastern Europe. Most notably, the US dollar has been strongest on a broad trade-weighted basis (heavy participation of EM currencies), the most important measure of the US currency's impact on the global economy, but made only very modest gains as measured by the DXY Index, which is skewed towards the G7 currencies.
Said differently, the US Dollar has seen its value appreciate the most against the currencies of most developing countries -- the emerging market economies. Many investors ascribe the strength of the US currency to the divergence in official monetary policies between the US and the Rest of the World (RoW). Specifically, investors point to the Fed's stance of tightening monetary policy for the rest of the year, possibly in four installments, as the FOMC's Summary of Economic Projections (SEP) dot plots seem to indicate. This contrasts with the easier policy expected from the ECB during the first half of 2016. On January 21, Mr. Mario Draghi, president of the ECB, set out a new stimulus program to take effect possibly in March, although he left policy rates unchanged during the January meeting of the central bank. The Bank of Japan has been reluctant to ease policy further, arguing that falling oil prices masks lurking inflationary pressure. But the Yen has been strengthening recently against the US Dollar, so many observers believe that the odds of a policy ease during the bank's January meeting has increased to more than 50 percent.
The US dollar is losing the FX "beauty contest"
But not all the macro factors remain in favor of the US currency. Against the EUR, the dollar's most stalwart rival, GDP growth spreads now lean towards the Eurozone, although the spread of the 2yr bond and 2yr bund (instruments closest to the official policy rates) is still in favor of the US Dollar (see chart below). The recent recovery of the EUR seems to be correlating better with the narrowing of the growth spread between the US and EU close to zero.
In a US-Japan comparison, it is even worse for the US currency. The variance in growth rates has moved to neutral; the US positive growth spread has narrowed to almost nil from as wide as 4.5 percentage points. At the same time, the 2-year swap spread has also narrowed sharply from a full percentage in favor of the USD to about 0.8 basis points today. These developments have helped strengthen the Yen versus the US dollar in recent weeks (see chart below).
There is a common thread among the reasons why the US Dollar is losing the FX "beauty contest". The long-expected rise in US interest rates as consequence of the Fed's tightening is not happening, and it may not happen at all during H1 2016. The sharp appreciation of the US Dollar from mid-2014 until late Q1 2015 has been based on those lofty expectations. It is not that the advantages of the US Dollar have been completely reversed -- it is just that whatever tightening the Fed can do has already been totally priced-in. For the US Dollar to strengthen further via this route, the Fed has to do much more than even the four hikes penciled-in the SEP dots.
The Fed did raise policy rates a month ago by 25 basis points, but much of what has happened thereafter has been counterintuitive - US short term rates have not risen in accordance to everyone's expectations. After a couple of weeks of rising rates, the policy-sensitive two-year Treasury yield basically collapsed from 1.09 pct on December 29 to 0.84 pct on January 22. US and global bonds have been falling, reacting to developments in the equity markets, in China, in the energy sector, and to a perceptible slowing down of the US economy (see chart below).
So it is obvious (at least to us) that the US Dollar strength is being driven by something else other than the much ballyhooed outlook for higher rates in the US that were supposed be delivered by tighter Fed policy. It is also becoming clear that divergence in policies between the US Fed and other major central banks, which has been a major linchpin in bullish arguments looking for further US dollar strength, may not get much traction at a time when the US economy struggles to stay off zero growth. It is unlikely, at least for now, that the Fed will be raising policy rates four times this year. That will not provide the US dollar much future support. If the US dollar has to maintain its upside momentum into H1 2016, as we believe it would, then support has to come from somewhere else.
Improving US capital account balance supports current and H1 US Dollar strength
We suggest instead that the US dollar's continuing strength is coming from the steady improvement of the US Capital Account Balance. The capital account balance reflects net change in ownership of national assets, and is one of the components of a country's Balance of Payments ledger, the other being the Current Account Balance. A surplus (or improvement) in the capital account balance means money is flowing into the country, the inbound flows represent non-resident borrowings or purchases of assets. A deficit (or deterioration) in the capital account means resident capital is flowing out of the country, in the pursuit of ownership of foreign assets. These statements are simplification of relatively intricate balance sheet operations, but they describe the flows well.
Although a higher interest rate relative to those of other major central banks tends to attract funds via the capital account, which acts to raise the value of the domestic currency (USD in this case), rate differentials may not be the primary impetus for the recent improvement of the capital account balance. For instance, anecdotal evidence of US real estate assets being attractive to external investors (e.g., Chinese fleeing from the falling CNY) have been highlighted in recent quarters, as in this story here. Foreigners are snapping up US residential and office building properties in increasing quantities, requiring more US Dollar denominated funds.
A recent Seeking Alpha article also said that "Top 20 insurance companies and pensions in China are setting their targets on American real estate to capitalize on our safe haven image. Companies such as Ping An Insurance are interested in investing billions into the United States real estate market and have gone so far as creating a US-based investment branch of the company. Other companies such as Anbang Insurance (owner of the Waldorf Astoria) and Fosun International (JPMorgan Manhattan Plaza) have already set up shop in the United States and are likely here to stay". See that story here.
The recent strong decline in yields (and appreciation in price) of US Treasury and agency bonds also provide some empirical evidence, via the Treasury International Capital (TIC) flows, that non-resident capital has been moving into the US fixed income markets. It is interesting to note that as bonds become cheaper, and the US dollar's exchange rate declines, the cross-border TIC volume picks up. Conversely, higher bond prices and firmer US Dollar exchange rate tend to slow down the inflows. This bit of information is useful to us, as we see it as evidence that non-resident investors have been buying US assets on price dips. That was true in the fixed income market, but we can only speculate if it was also true in the equity markets (see chart below).
The latest TIC data (for November 2015) shows that inflows remain strong. Foreign investors net bought $45bn in long-term fixed income US securities, compared with $17bn/month over the six months period before that. The purchases in November were driven by $38bn in coupon Treasuries, $4bn in GSEs, and $3bn in corporate debt securities. The $38bn in net purchases in coupon Treasuries in November is significantly more than the average pace of just $4bn/month over the past six months. Another survey, the Treasury holdings data, also show that coupon Treasury holdings rose $26bn in November, driven by demand from both China (and Belgium) and the financial centers (e.g., the UK, Switzerland, Cayman Islands, Caribbean banking centers, Ireland, and Luxembourg).
Changes in the US capital account balance lead USD changes by 2 quarters
Changes in the US capital account normally show up in the valuation changes of the US currency 2 to 3 quarters later. Capital accounts improve when non-resident (external) capital inflows increase or resident (domestic) capital outflows slow. The sharp improvement in the domestic capital account during the last three quarters of 2015 will therefore likely to result in further rise of the US dollar during H1 this year (see chart below).
Putting all the elements together
Interpretation of the balance of payment ledger could be nuanced, so it is critical to obtain evidence that the putative relationship between changes in the capital account and changes in the US dollar that we claim are indeed valid and operational at this time. We have taken the following steps:
First, we showed the correlations between global growth, the US dollar and the EUR/USD. The relationship is positive between the euro and global GDP, and negative between the US dollar and global growth. In more direct terms, the US dollar firms up when global growth wanes, and the EUR strengthens when global growth picks up (see chart below). In effect, we want to show that there is a negative link between the US Dollar and global growth (and vice versa).
Second, we selected a survey-based leading indicator for global growth that has a long success history. We chose the IFO Institute's WES economic situation in 6 months to provide the near-term outlook. The chart below shows how changes in global GDP and changes in the US Dollar match with the twists and turns of the WES economic outlook in 6 months. There are reasonably good matches between the changes in the variables (see chart below).
Third, we determined whether or not the WES survey has predictive property relating to future developments of the US current account balance, and if changes in the US current account balance can be explained by broad changes in global growth. The answer is affirmative on both counts (see chart below): the WES outlook correlates well with the US capital account, and the US capital in turn, provides a high-frequency summary of the evolving global GDP.
Finally, we wanted evidence that the WES outlook and the US capital account balance can project a 6-month path for the US Dollar with some reasonably good outcomes. We are satisfied that both variables deliver what we require (see chart below).
To square the circle, we also decided to see if the Treasury TIC flows may have some correlation with either the US capital account balance or with the WES outlook. TIC flows correlate well with the changes in US capital account balance (as should be expected), but the TIC flow-WES outlook relationship is not as well as we expected (see chart below).
Summary and conclusions:
Continuing strength of the US Dollar into H1 would have repercussions to a lot of assets and asset classes. The commodities asset class will remain under pressure if this projection happens, and so does the price of crude oil, which currently has the highest negative correlation to the dollar among commodities -- the price of oil could remain on a downtrend until early Q2 at least. Precious metals, which have shown some life lately as a consequence of lower US growth outlook, could come under pressure again if the USD surges anew, and are at risk of making marginally new lows further out. Base metals may also come under pressure, which may be mitigated by "better" outlook coming from China later, during H2. The agriculture sector should feel the sting of a stronger US dollar as well, but prices in this sector may be supported by still escalating effects of the El Nino phenomenon at the mid-Pacific Ocean, neutralizing the effect of a stronger Dollar.
Another surge in US dollar strength may contribute further to stresses in the Chinese economy -- a stronger US dollar piles further pressure on the Chinese CNY (a strong USD has been one of the proximate causes of domestic capital outflows looking for better alternatives to the weakening CNY). China does need a weaker currency, but a CNY collapse would be catastrophic domestically, especially to its corporate sector -- CNY devaluation would make it harder for Chinese corporates to repay dollar-denominated debt. A rapid CNY devaluation would also impact global economies as its consequent deflationary impact would be exported to the RoW. Moreover, further capital outflows may again force China's central bank to defend and buy back the currency. In doing so, currency reserves are further frittered away, which would also act to keep monetary conditions unnecessarily tighter. Collectively, all these may hinder an economic recovery in China, which we otherwise expect to make a trough in H2 2016. Our reasons for optimism in the Middle Kingdom: Chinese consumers are still spending, property prices are stabilizing, demand for exports has picked up some, imports have been moving well in recent months, and there is plenty of room for fiscal and monetary stimulus if required. We are concerned that a growth pick-up is taking longer than we expected, but we do not fear a hard landing. Our biggest concern: policy missteps which could lead to a sharp, one-time currency devaluation as a last-resort option. If fears of a CNY collapse do not come to pass, it may be that base metals would be one of the best performers among the commodity sectors during late H2 2106.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: The company the author represents may have outstanding long or short positions in the commodities discussed in the article. The company may also initiate new positions, long or short, in any of those commodities mentioned, within 72 hours of publication of this article.