USD comeback – trend reversal or dead-cat bounce?

What caused the USD revival and why it should strengthen further


The US dollar is back. After falling 11% last year, the analyst community has been quick to extrapolate this move into 2018. Now well into 2018, the Greenback is up 5% from the lows in February, taking the market by surprise. Why is the dollar comeback such a big deal? In short, a cheaper USD amounts to a positive global liquidity shock, a higher dollar is a negative liquidity shock.  The USD is the world’s funding currency no. 1. More than 2/3 of emerging market debt is denominated in dollars. A cheaper dollar therefore means cheap funding. This spurred risk appetite and leverage last year. But when the dollar strengthens, debt values and debt servicing costs go up relative to income, undermining creditworthiness of dollar borrowers.

It is, therefore, front and centre where the US dollar goes from here. Whether this is the end of the dollar demise or a temporary recovery naturally depends on the drivers behind its comeback. So why has it been so strong? We think three D’s are at play:

  1. Divergence of inflation: As opposed to 2017, inflation in the US is surprising to the upside, while inflation in Europe and China is weakening. More inflation divergence (see Figure 1) makes for more policy divergence. The US Fed is more likely to surprise on the hawkish side, while other central banks might react more dovishly than expected, supporting the Greenback. Case in point, the Chinese central bank recently loosened banks’ reserve requirements and the US-Chinese interest rate spread widened. The ECB is still at pains to announce the end of its bond buying programme.
  2. De-synchronisation of global growth: The “synchronised recovery” narrative dominating 2017 is slowly being replaced by a “desynchronised slowing”. First, overall global growth is slowing as monetary tightening is beginning to bite. Second, some regions (Europe in particular) are performing significantly worse than the US in terms of economic surprises. In contrast, most regions moved in tandem last year. This means less capital is flowing from the US into higher yielding regions where expected returns are higher in good times. Call this a less “carry friendly” environment, contributing to USD strength.
  3. Discount rate trigger: The US 10-year Treasury yield breached the psychologically important 3% level recently, causing investors to stop ignoring the huge cross-Atlantic yield divergence, which as such has pointed towards a stronger US dollar for quite some time now. As US yield levels become more attractive, the hunt for yield is all of a sudden becoming a tailwind for the USD and US fixed income.

The macro message: It doesn’t stop here

What are these factors telling us about the future path of the Dollar? In our view, the USD should strengthen further towards year-end. First, inflation divergence is here to stay. Chinese inflation, in particular, has room to fall further. Also, it seems to us that the ECB will have to tone down its tapering ambitions, weakening the Euro. Secondly, desynchronised growth is supported by Trump’s tax cuts lifting US growth, while at the same time the Euro Area is suffering from last year’s Euro strength. In addition, slower Chinese credit growth is a headwind to the world’s second biggest economy. Third, although we do not expect Treasury yields to rise much from here, the relative yield argument pro USD is unlikely to weaken. It is difficult to see the ECB taking the lid off Euro rates through its bond buying when growth slows and inflation is miles away from target.

Opportunities and threats: A stronger dollar changes the investment landscape

Although we do not expect the US dollar to sky-rocket, its revival means investors need to navigate an environment of tighter monetary conditions, driven by a double whammy of a hawkish Fed and US currency strength. This stands in sharp contrast to last year’s market environment. To be clear, the recent EM woes are all about USD strength,, as the region is most dependent on foreign dollar liquidity. There’s little EM countries can do about this. And so far, the US Fed’s stance is “it’s our dollar, but your problem”. Consequently, Emerging Markets (EM) assets will have harder times ahead and investors have to be more selective among regions and countries as last year’s hunt-for-yield driven appetite for EM assets is weakening. Within EM, local currency bonds should underperform hard currency bonds for the rest of 2018.

 Yield-hungry investors do not need to look into relatively risky EM bonds. They now find attractive yields in US core fixed income, with a better risk reward given the recent dollar-driven EM woes. The yield pick-up in the US has been attractive for a while, seen from a European perspective, but many EU investors have been scared by currency risks and/or high hedging costs in the wake of last year’s USD down-trend. As we expect the macro dynamics described above to support the Greenback going forward, it is worthwhile to take on some currency risks.  The yield pick-up stands at a multi-decade high, both in short and longer maturities, when comparing US Treasuries with German government bonds.

Figure 1: Why so strong? Divergence is driving the dollar up

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About Nordea Asset Management

Nordea Asset Management (NAM, AuM 216.5 bn EUR*), is part of the Nordea Group, the largest financial services group in Northern Europe (AuM 320.1 bn EUR*). NAM offers European and global investors’ exposure to a broad set of investment funds. We serve a wide range of clients and distributors which include banks, asset managers, independent financial advisors and insurance companies.

Nordea Asset Management has a presence in Cologne, Copenhagen, Frankfurt, Helsinki, London, Luxembourg, Madrid, Milan, New York, Oslo, Paris, Sao Paulo, Singapore, Stockholm, Vienna and Zurich. Nordea’s local presence goes hand in hand with the objective of being accessible and offering the best service to clients.

Nordea’s success is based on a sustainable and unique multi-boutique approach that combines the expertise of specialised internal boutiques with exclusive external competences allowing us to deliver alpha in a stable way for the benefit of our clients. NAM solutions cover all asset classes from fixed income and equity to multi asset solutions, and manage local and European as well as US, global and emerging market products.

*Source: Nordea Investment Funds, S.A., 31.03.2018

Nordea Asset Management is the functional name of the asset management business conducted by the legal entities Nordea Investment Funds S.A. and Nordea Investment Management AB (“the Legal Entities”) and their branches, subsidiaries and representative offices. This document is intended to provide the reader with information on Nordea’s specific capabilities. This document (or any views or opinions expressed in this document) does not amount to an investment advice nor does it constitute a recommendation to invest in any financial product, investment structure or instrument, to enter into or unwind any transaction or to participate in any particular trading strategy. This document is not an offer to buy or sell, or a solicitation of an offer to buy or sell any security or instruments or to participate to any such trading strategy. Any such offering may be made only by an Offering Memorandum, or any similar contractual arrangement. Consequently, the information contained herein will be superseded in its entirety by such Offering Memorandum or contractual arrangement in its final form. Any investment decision should therefore only be based on the final legal documentation, without limitation and if applicable, Offering Memorandum, contractual arrangement, any relevant prospectus and the latest key investor information document (where applicable) relating to the investment. The appropriateness of an investment or strategy will depend on an investor’s full circumstances and objectives. Nordea Investment Management recommends that investors independently evaluate particular investments and strategies as well as encourages investors to seek the advice of independent financial advisors when deemed relevant by the investor. Any products, securities, instruments or strategies discussed in this document may not be suitable for all investors. This document contains information which has been taken from a number of sources. While the information herein is considered to be correct, no representation or warranty can be given on the ultimate accuracy or completeness of such information and investors may use further sources to form a well-informed investment decision. Prospective investors or counterparties should discuss with their professional tax, legal, accounting and other adviser(s) with regards to the potential effect of any investment that they may enter into, including the possible risks and benefits of such investment. Prospective investors or counterparties should also fully understand the potential investment and ascertain that they have made an independent assessment of the appropriateness of such potential investment, based solely on their own intentions and ambitions. Investments in derivative and foreign exchange related transactions may be subject to significant fluctuations which may affect the value of an investment. Investments in Emerging Markets involve a higher element of risk. The value of the investment can greatly fluctuate and cannot be ensured. Investments in equity and debt instruments issued by banks could bear the risk of being subject to the bail-in mechanism (meaning that equity and debt instruments could be written down in order to ensure that most unsecured creditors of an institution bear appropriate losses) as foreseen in EU Directive 2014/59/EU. Nordea Asset Management has decided to bear the cost for research, i.e. such cost is covered by existing fee arrangements (Management-/Administration-Fee). Published and created by the Legal Entities adherent to Nordea Asset Management. The Legal Entities are licensed and supervised by the Financial Supervisory Authority in Sweden, Finland and Luxembourg respectively. The Legal Entities’ branches, subsidiaries and representative offices are licensed as well as regulated by their local financial supervisory authority in their respective country of domiciliation. Source (unless otherwise stated): Nordea Investment Funds, S.A. Unless otherwise stated, all views expressed are those of the Legal Entities adherent to Nordea Asset Management and any of the Legal Entities’ branches, subsidiaries and representative offices. This document may not be reproduced or circulated without prior permission. Reference to companies or other investments mentioned within this document should not be construed as a recommendation to the investor to buy or sell the same, but is included for the purpose of illustration. The level of tax benefits and liabilities will depend on individual circumstances and may be subject to change in the future. © The Legal Entities adherent to Nordea Asset Management and any of the Legal Entities’ branches, subsidiaries and/or representative offices.

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