U.S. Dollar Caught Between Two Opposing Trends

From Invesco: Invesco Fixed Income shares its views on currencies around the world, including expectations for a neutral dollar.

US dollar: Neutral. We believe the US dollar is caught between two trends. Interest rate hikes and balance sheet reduction by the US Federal Reserve (Fed) have increased US dollar funding costs and tightened financial conditions, spurring the dollar rally. Uncertainty over trade policy has exacerbated the move. On the other hand, global growth has been strong and it appears that US economic activity, while buoyant, has peaked — a convergence that typically causes the US dollar to weaken.

Euro: Neutral. The euro/US dollar exchange rate breached a key support level of 1.15 in August, while risk aversion across emerging market currencies (sparked by Turkey) continued to spur the US dollar higher.1The fundamental economic picture has improved in the euro area, but exogenous factors driving sentiment across currency markets are unpredictable, keeping us sidelined for now. 

Renminbi: Neutral. The renminbi/US dollar exchange rate traded between 6.80 and 6.95 in August.2 In addition to the counter-cyclical adjustment factored into the daily fixing rate and the reserve requirement of 20% on foreign exchange forwards, the People’s Bank of China has banned interbank renminbi deposits and loans to the offshore market through free trade zones.3 This move likely led the exchange rate to quickly drop from 6.95 to 6.84.4 Capital controls for outflows remain tight, but financial opening, such as the inclusion of Chinese equities and onshore bonds in major global indexes, will probably further increase overseas demand for Chinese onshore assets and could help maintain stable capital flows. We expect the exchange rate to hover around 6.8 to 6.9 in the near term. However, positive headlines related to US-China trade negotiations could cause the exchange rate to trade below 6.80. 

Japanese yen: Overweight. The yen has benefited from the recent spike in volatility and deteriorating risk sentiment caused by the Turkish asset selloff. The yen/US dollar exchange rate traded down from about 112 at the beginning of August to a low of 110.1 as the selloff in the Turkish lira peaked.5 Looking ahead, we believe that the Bank of Japan policy tweak (which increased the target for 10-year yields) will support the yen, and the current valuation looks attractive. However, the exception to our view is the potential for broader US dollar strength driven by Fed policy and reduced global risk appetite from continuing trade tensions. We believe the yen may be sidelined against the US dollar in this scenario but will likely outperform versus other currencies. 

British pound sterling: Neutral. Sterling is likely to be driven by developments in Brexit discussions and expectations for UK interest rate hikes. We do not expect a breakthrough on Brexit anytime soon, but the Bank of England delivered a unanimous 0.25% rate hike to 0.75% in its August meeting as widely expected.6It also revised its growth and inflation forecasts upwards. However, Governor Mark Carney signaled that policy tightening would remain gradual and the chance of a no-deal Brexit is “uncomfortably high.” After this statement, the sterling/US dollar exchange rate weakened below 1.30.7 Over the medium term, we continue to expect sterling to appreciate, but will need some positive developments from Brexit negotiations for this to materialize. 

Canadian dollar: Neutral. The Canadian dollar has remained in a slow decline this year, although it has outperformed other “dollar-bloc” currencies such as the Australian and New Zealand dollars. The Bank of Canada policy rate hike to 1.50% in July did nothing to alter the path of the currency.Skepticism over resolving the ongoing NAFTA trade negotiations remains a huge hurdle. In addition, foreign demand for the currency driven by investment in Canadian real estate has been declining. 

Australian dollar: Underweight. The Australian dollar continues to struggle as the country remains in the crossfire of the trade war between the US and China. The housing market continues to show signs of cooling (although at a gradual pace), and commodity prices remain under pressure. With the Reserve Bank of Australia in no rush to raise its policy rate and no end in sight to the trade disputes, we do not currently see a catalyst to drive the Australian dollar higher and expect it to remain under pressure. 

Indian rupee: Underweight. The rupee has experienced a significant sell-off, depreciating 8.64% year-to-date against the US dollar.9 In our view, this was largely driven by an increase in crude oil prices, foreign portfolio outflows and investor fears of a higher current account deficit. Looking ahead, we believe risks to the rupee continue to be tilted to the downside as India’s balance of payments remains under pressure from portfolio outflows, higher crude prices and higher trade deficits.

1 Source: Bloomberg L.P., Aug. 15, 2018.

2 Source: Bloomberg L.P., Aug. 1, 2018 to Aug. 24, 2018.

3 Source: People’s Bank of China, Aug. 3, 2018.

4 Source: Bloomberg L.P., Aug. 15, 2018 to Aug. 17, 2018.

5 Source: Bloomberg L.P., Aug. 1, 2018, Aug. 20, 2018.

6 Source: Bank of England, Aug. 2, 2018.

7 Source: Bloomberg L.P., Aug. 6, 2018.

8 Source: Bank of Canada, July 11, 2018.

9 Source: Bloomberg L.P., Aug. 24, 2018.

Important information

A dollar-bloc currency is one that derives its value primarily from the value of the US dollar. Currently, the Australian, New Zealand and Canadian dollars comprise the group of dollar-bloc currencies.

The risks of investing in securities of foreign issuers, including emerging market issuers, can include fluctuations in foreign currencies, political and economic instability, and foreign taxation issues.

The performance of an investment concentrated in issuers of a certain region or country is expected to be closely tied to conditions within that region and to be more volatile than more geographically diversified investments.

The dollar value of foreign investments will be affected by changes in the exchange rates between the dollar and the currencies in which those investments are traded.

The Invesco DB US Dollar Bullish (UUP) was unchanged in premarket trading Friday. Year-to-date, UUP has gained 4.91%, versus a 8.41% rise in the benchmark S&P 500 index during the same period.

UUP currently has an ETF Daily News SMART Grade of A (Strong Buy), and is ranked #1 of 17 ETFs in the Currency ETFs category.

This article is brought to you courtesy of Invesco.