Hot topics for 2018
The US dollar, yield curves, oil and all that …
A preview of the 2018 Outlook by Witold Bahrke, Senior Macro Analyst at Nordea Asset Management
What should we expect from the US central bank and how will it impact currencies?
In short, the Greenback is in for a bit of a comeback in the medium term, although we might see some more weakness short term if Trump’s tax plans disappoint. The Fed is tightening – both conventionally via higher rates and unconventionally via a balance sheet reduction. While the Fed is largely flying blind as it is reversing the biggest experiment in recent monetary history, we expect the USD to strengthen moderately relative to most other currencies over the coming months, also vis-a-vis the Euro. The Fed’s balance sheet reduction will result in less USD liquidity flowing to the markets. Both the ECB and the BoJ, on the other hand, are still expanding their balance sheets, pointing towards US dollar strength.
But there are also other factors at play. In the short term, the USD is benefitting from less excess liquidity in the US financial system as the US Treasury is rebuilding its cash balance after the debt ceiling has been lifted temporarily. Also, the relative macro picture does not favour Europe as much as it did just a few months ago. Case in point, the economic data is surprisingly less positive in Europa compared to the US lately (graph 1).
More medium term, the US business cycle is still much stronger than other G7 countries’ business cycles (graph 2). This has traditionally led to a stronger US dollar, amongst others via a tighter monetary policy. Therefore, we think it is too early to expect a downward trend in the USD. To the contrary, the recent US dollar weakness seems a bit overdone. Finally, the market seems very short positioned on the US dollar (graph 3). This suggests it is still a good time to position for a stronger US dollar in the medium term.
Which currencies are likely to weaken the most against the Greenback? We think EM currencies are most at risk (graph 4). The EM region as a whole has been a huge beneficiary of the weak US dollar YTD. Why? Because the USD is still the world’s number 1 funding currency and large parts of EM are still using big chunks of (so far) cheap USD funding. As liquidity growth dries up, EM is likely to see some capital outflows, weakening their currencies (and therefore revenues). Commodity intensive regions are especially vulnerable, since a stronger USD normally implies weak commodity prices, absent any significant supply shocks.