- We expect the U.S. dollar to rise this year, albeit at a slower pace than in the recent past and with bumps along the way.
- The U.S. dollar weakened after President-elect Donald Trump’s first media conference, losing a third of its post-election gains.
- This week may bring more signs of global reflation, updated Federal Reserve rate expectations and more Brexit clarity.
1. A more measured dollar rally
We expect the U.S. dollar to grind higher this year. But the pace of the greenback’s rise is likely to moderate, with spates of volatility similar to last week’s drop following Trump’s first media conference since winning the election.
Chart of the week
Yield differential and the U.S. dollar, 1990-2017
U.S.-led economic reflation, Federal Reserve rate increases and expectations of fiscal stimulus are likely to widen the gap between U.S. and overseas interest rates. A higher yield differential in favour of the U.S. has in the past typically spurred more foreign purchases of U.S. bonds, supporting the U.S. dollar, as the chart shows.
Running on fumes?
Currency trends can be long-lasting. Yet we see a more measured dollar rally ahead, after a nearly four-year run that has already lifted the greenback close to all-time highs on a broad trade-weighted basis.
Various estimates of the dollar’s fair value, based on economic fundamentals, now find it about 15% overvalued. Corporate tax reform proposals in the U.S. could prompt significant expectations for further dollar appreciation, driven by the potential impact on trade and the repatriation of corporate profits held overseas. Yet there is still great uncertainty around the details, timing and potential impact of the incoming Trump administration’s policies. Bottom line: We see potential for currency volatility ahead, but little risk of a sharp and disruptive dollar rally.
Rapid gains in the dollar would be a key risk to U.S. corporate earnings. A mild rise would limit the damage, as well as any potential spillover effects to countries and companies with dollar liabilities. Big declines in many emerging market currencies have helped narrow current account deficits in the emerging world, making countries more resilient to bouts of dollar strength. Lastly, yen and euro weakness against the dollar is partly why we recently upgraded our views on Japanese and eurozone stocks.
- The dollar gave up a third of its post-election gains after Trump offered little policy details in his Jan. 11 media conference. U.S. small business confidence hit a 12-year high.
- Expectations for monetary tightening grew after China’s December Producer Price Index jumped the most in more than five years, and credit grew faster than expected.
- The Italian Constitutional Court voted to block a referendum to roll back labour reforms, while the British pound slid on fears of a “hard Brexit.”
|Jan. 17||UK Prime Minister Theresa May speech on Brexit|
|Jan. 18||Eurozone, U.S. Consumer Price Index (CPI); Fed Chair Janet Yellen speech on economy|
|Jan. 19||European Central Bank (ECB) meets; Yellen speech|
|Jan. 20||China industrial production, retail sales; Trump inauguration|
The ECB is likely to keep policy unchanged, looking past a recent pickup in headline inflation. Yellen’s comments may influence expectations for the pace of rate hikes. Any signs the UK will leave the single market could trigger a further fall in the pound.
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Sources: Bloomberg unless otherwise specified.
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