While the discussion about a new up-leg of the US dollar has heated up, investors are failing to realize that there are too many global headwinds for this to happen at the moment. The US dollar index (NYSEARCA:UUP), which measures the value of the USD against its six most important peers (Euro, yen, sterling, Canadian dollar, Swedish krona, and Swiss franc), has been trapped in a sideways zone for two long years. The last two times the US Dollar index tried to break the 100 level it pulled back. Will it manage to penetrate this well-held resistance, this time around? Chances are it won't. A plethora of global macro circumstances, spanning from USD carry trades, to resurgent inflationary expectations across the globe, will most certainly keep the USD from soaring. This means that unless a huge global crisis breaks out, investors should brace themselves for an unusually trendless greenback.
Will USD Carry Trade Unwind?
USD bulls use a bunch of macro arguments to support that an imminent and sizeable dollar up-leg will occur, similar to that of 2014, maybe not in price but certainly in momentum. One such argument is that the US dollar carry trades, which inflicted much selling pressure to the currency, will start to reverse, in response to the uptrend in domestic bond yields. Such carry trades involve borrowing in USD, exchanging the proceeds for a foreign currency, and then using that money to buy higher yielding bonds of that currency. When this action is repeated excessively it causes selling pressure to the US dollar, since investors constantly need to exchange the borrowed dollars. Rising government bond yields in the US, the bulls say, will make the investment in US Treasuries or in other high-quality bonds, more lucrative than their emerging market counterparts. This will unwind the USD carry trades, bringing back sizeable inflows to the dollar. These inflows will then inflict upward pressure, resulting to a massive USD uptrend.
While this approach seems logical, it has severe limitations. In order for it to work it would require USD yields to increase more than their emerging market counterparts. However, if the US economy were to exhibit resurgence in its domestic demand and inflation, something required for a rise in US Treasury yields, it wouldn't be the US that would benefit but Asian markets instead. The reason is that the US is the single most important trading partner of China, and the latter holds a bilateral trade surplus with the former, which in simple terms means that China exports much more than it imports from the US. A stronger American economy would spur demand for more imports from China. This would in turn strengthen the Chinese economy enough to shield it from devaluating its currency any further. A strong China with a less devalued currency inherently would drive Chinese yields higher. So, in essence, if the USD bull scenario prevails, more invective to buy foreign bonds will exist rather than US ones. After all, the income elasticity of the US demand for imports, i.e. how fast demand responds to an increase in domestic income, is far greater than their exchange rate elasticity i.e. how fast demand responds to yuan devaluation. In other words a stronger US economy would benefit China much more.
To add to the mix such a boost to the Chinese economy would, in turn, increase its demand for imports from other countries in the Asia Pacific region, which happen to be its major suppliers for industrial parts. Higher economic activity across the region would fuel consumer spending, which in turn would speed up inflation. Higher inflationary pressures would ultimately force the PBoC and other Asian central banks to tighten their policies, and this would be an additional reason as to why Asian bond yields would rise. Corporate bond yields across Asia Pacific would also follow suit for the same reasons.
In fact, this phenomenon could already be underway, as various foreign government bond yields have rebounded faster than the corresponding US yields. Taiwan 10-Year government bond yields, for example, have been surging at a rapid pace, the fastest in three years actually. This is not a coincidence if one considers that 25% of Taiwanese exports are absorbed by China and 12% by the US. Any sign of growth in these two economies will certainly benefit Taiwan, and from the looks of it, it seems that it has already started doing so.
Other examples of this phenomenon could be seen in the recent jump of Thailand's 10-Year bond yields, as well as Australia's and New Zealand's. If such an uptrend in Asia Pacific bond yields spreads all across the region then it would certainly provide more reasons for global investors to keep engaging in their USD carry trades, adding more pressure to the US dollar. Under such light it is hard to imagine how a steady uptrend in US yields could unwind the massive USD carry trade, in order for the dollar outflows to turn into inflows again. So the USD bull scenario has severe limitations and it could end up having a boomerang effect. It seems that the greenback is truly stuck between a rock and a hard place.
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