Exploring The Source Of The Dollar's Newfound Strength

by: Alpha Source

Summary

As the dollar continues to appreciate, it becomes critical for investors to understand the main catalyst and adapt accordingly.

The market impact of a rapidly strengthening dollar could have grave implications for the global economy.

As economic growth in the euro area decelerates, the greenback is emerging as the primary beneficiary.

In recent weeks, the strength of the US dollar has caught most market participants off guard. While it is reasonable to view this trend as a benign phenomenon, in line with shifting fundamentals in the global economy, its implications for investors and traders are quite significant. History provides ample evidence that the risks associated with a sharp appreciation of the greenback should not be underestimated. This is especially true in the context of relatively subdued financial markets and artificially low interest rates, where the continued weakness in the dollar was perceived as a near certainty not so long ago, following a protracted period of relentless declines. As a result, it is essential to identify the main factors contributing to the dollar’s newfound strength and assess their durability going forward.

Unsurprisingly, the misconception that the greenback’s downtrend would be impossible to reverse gave rise to an acutely lopsided market positioning with hedge funds and large speculators betting heavily on accelerating losses for the global reserve currency. But, as is often the case, the market’s overconfidence that the trend would endure actually fueled a sharp price reversal. Nonetheless, the bearish sentiment among speculators has remained surprisingly strong, which counterintuitively suggests that the dollar’s rebound has room for further upside. This is particularly consequential both from a technical and a fundamental perspective.

The US dollar’s appreciation since mid-April has been underpinned by the resolve of the Federal Reserve to confidently continue the process of policy normalization, unfazed by the less favorable environment in the global economy and despite the potential implications of the escalating trade tensions between the world’s two largest economies. The Fed’s confidence is rooted in the positive economic data of recent months, which have vindicated those expecting a higher level of growth in the United States. While inflation remains elusive, the accelerating economic momentum is bound to intensify inflationary pressures in the months ahead. Moreover, with growth differentials increasingly favoring the United States, the greenback is likely to find solid support. The combination of higher interest rates in the US and anemic growth in the rest of the world is set to anchor the dollar’s climb in the following quarters.

One of the key drivers of market action in 2017 was the notable optimism about the global economy as a result of numerous positive economic surprises in Europe and Japan, in combination with market-friendly results in many crucial elections across the globe. Market confidence was also anchored by what was perceived by investors and traders as a soft landing for China’s economy. Against this backdrop, it was natural for capital flows into Europe, Japan and major emerging economies to increase significantly, which was partly why the trade-weighted dollar index declined by approximately 10 percent; a move that confounded most analysts who expected that rising Treasury yields and pro-growth legislation would result in immediate US dollar appreciation. Nonetheless, what we are finally experiencing in 2018 is essentially a reversal of fortune for the greenback, as the US economy remains strong while worries about other major economies continue to grow. The latest news coming out of Europe provide an illustrating example.

It goes without saying that the likelihood of more gains for the greenback will rise exponentially if the economic recovery in the euro area continues to falter. Indeed, after several months of positive results, the economic expansion across Europe is starting to decelerate in the face of major structural headwinds. With inflation slowing, retail sales growth sagging and business confidence waning, investors are increasingly focusing on the deceleration in the eurozone economy. Meanwhile, the vice president of the ECB warned last week that the ongoing rise in the yields of US Treasury bonds and the subsequent strengthening of the dollar pose a major challenge for emerging economies and could destabilize financial markets.

Despite the upcoming boost from the increased competitiveness and enhanced corporate profits triggered by a lower euro, a sharp downturn in global markets as a result of resurfacing financial instability could again thrust the glaring vulnerabilities of the EU construct into the markets’ spotlight. Recent events in Italy, where the two populist parties appear determined to follow a controversial policy path that could ultimately shatter the European dream as a whole, underscore the gravity of the underlying systemic risk not only for the eurozone but more broadly for the global economy. And the growing threat of an international financial crisis is likely to underpin demand for the US dollar, which remains a traditional safe haven.

In sum, the US dollar is entering a period of strength, buttressed by weakening growth momentum in the rest of the world. The capital flows chasing returns abroad are gradually returning home, which is compounded by the repatriated overseas capital unleashed by the tax overhaul. These economic and financial forces are likely to prove durable, supporting the thesis for sustained US dollar strength. There is no denying that this can also be viewed as the symptom of a much broader phenomenon, namely the secular realignment of the world economy that is gathering steam. In that regard, a rapidly appreciating US dollar would be an exceptionally negative development, complicating the ongoing trade negotiations and adding an unsettling level of risk for many emerging market economies that remain fragile and structurally vulnerable to exogenous shocks. To put it simply, a strengthening greenback might be a largely positive development over the longer-term, but only as long as its appreciation is gradual and orderly, without accelerating to the degree that it jeopardizes the stability of financial markets.

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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.