Dollar – Diversification, rotation and valuations
Media and analyst reports focussing on the scope for further US Dollar weakness and Emerging Market currency outperformance have continued to proliferate in the past month.
The consensus view is still seemingly that a Democratic administration will fuel large US twin deficits and expectations of higher domestics inflation while Fed will keep rates on hold, eroding the value of Dollar assets. At the same time a pick-up in global confidence, economic growth and risk appetite will benefit EM and commodity currencies.
While the “safe-haven” Dollar weakened sharply and EM currencies outperformed in the wake of the US elections on 3rd November recent facts tell a different story. Since 10th December the Dollar Nominal Effective Exchange Rate (NEER) and GDP-weighted baskets of developed and EM currencies have been broadly flat according to our calculations.
Central European and Latin American currencies, which outperformed in November, have underperformed in past five weeks. Emerging Asian currencies, including the Chinese Renminbi, have done little since 10th December pointing to still active central bank FX management. This price action has broadly tallied with our near-term view that EM currencies will be “prone to sharp sell-offs (even if short-lived)”.
Our analysis suggests that the steepness of the US Treasury yield curve rather than inter-country yield spreads matters more for the Dollar.
However, we think central banks and sovereign wealth funds’ diversification out of Dollars into other reserve currencies, including Euro, Sterling, and Canadian, Australian and Kiwi Dollars, between May and early December was the main driver of Dollar depreciation.
Dollar NEER’s stability since 10th despite a further 2.7% gain in the S&P 500 suggests this diversification process has stalled, which we think is partly due to stretched valuations. At the same time price action points to a rotation out of the Euro into Sterling.
We stick with our view that Dollar depreciation may not resume for another couple of months and will in any case not be as broad based as in November/early-December with markets paying greater attention to domestic factors, including valuations.
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Olivier is an economist and rates & FX strategist with over 22 years experience in financial markets. He is Director and Founder of 4X Global Research, an independent, London-based consultancy which provides institutional and corporate clients with substantive research, high-quality analysis and insight on emerging and G20 economies and financial markets.