‘The beginning of the end’ of the U.S. dollar rally: HSBC

Share

Over the past nine months, the single biggest driver of price action across all asset classes has been the skyrocketing U.S. dollar.

This development has crimped the overseas earnings of major U.S. multinationals, accentuated the slide in oil prices, and reflects the conventional wisdom that the Federal Reserve will embark upon a tightening phase while the rest of the world largely continues to ease policy.

Since the end of June, 2014, the U.S. dollar index, which tracks the greenback's performance relative to a basket of major currencies, has risen by 25 per cent.

However, the Federal Reserve's dovish releases on Wednesday threw a massive wrench into the greenback's one-way ticket to the stratosphere.

While the Fed removed the word "patient" from the statement, technically putting a June rate hike on the table, monetary policy makers' estimated glide path higher for rates is slower than it was in December, and the growth outlook for the next three years was downgraded.

The U.S. dollar index proceeded to tumble by more than 2.5 per cent from the 10 minutes preceding the statement until equity markets closed.

On Thursday, David Bloom, Global Head of foreign exchange strategy at HSBC, made the case that we've reached the "beginning of the end of the bull run" in the U.S. dollar rather than in the middle of one, as is commonly thought.

This might seem like a knee-jerk response to the market's immediate reaction, but Mr. Bloom cites a number of factors to back up his argument:

· Recent data developments

· U.S. tolerance for U.S. dollar strength has its limits

· Valuations

· Positioning/U.S. dollar bullishness has become all-pervasive

· Greenback does not perform once Fed has actually pulled the trigger

Positioning on the U.S. dollar is, no doubt, at extreme levels – leaving it vulnerable to abrupt reversals, as seen on Wednesday afternoon.

But U.S. dollar bulls will hang their hats on the entrenched belief that the Federal Reserve will decouple from most of its peers and begin to raise rates. However, Mr. Bloom deems this argument to be "stale."

"The difficulty is that a bull needs feeding, and this story has already been digested," he said.

The strategist also observes that while the U.S. economy's rate of expansion is expected to exceed its peers this year, disappointing data early in this year cannot be ignored in perpetuity.

To a certain extent, however, this subpar data can be chalked up to seasonal influences – Citigroup's U.S. economic surprise index often trends downward in the first two quarters of the year.

The Globe's Scott Barlow has drawn attention to the psychological factors underpinning this seasonality: Economists typically start off the year optimistic about what's to come, and get browbeaten into being overly pessimistic following a string of underwhelming economic data. Over the past two years, however, more severe than usual winter weather has also weighed on first-quarter figures.

An underlying message derived from Wednesday's releases and commentary from Fed Chair Janet Yellen is that the strength of the U.S. dollar is hampering the American economy, leading some to believe the Federal Reserve is less than thrilled by the appreciation of the currency.

As Bloomberg's Matthew Boesler pointed out, the Fed statement highlighted softening export growth – a segment that hadn't been explicitly mentioned in one of these releases since March, 2009.

Separately, Ms. Yellen indicated that net exports will serve as a drag on activity this year, as the rise of the greenback makes American goods and services more expensive to foreigners.

Taking a look back to the commencement of previous tightening cycles, Mr. Bloom also demonstrates that the U.S. dollar index has weakened in the 100 days following the first hike.

"On each occasion, the USD fell even though there were additional rate increases made during the period," he said.

"'Buy the rumour, sell the fact' would seem the appropriate strategy."

Mr. Bloom acknowledges that there is the possibility for another spike in the greenback before this rally concludes. If this rally continues for a prolonged stretch, however, he claims it will be "a destructive USD surge" prompted by one of the following tail risks: an emerging markets currency crisis, euro zone break-up, forced repatriation of U.S. corporate profits held abroad, or the failure of Japan's attempt to rejuvenate its economy.

A falling U.S. dollar would likely give commodity prices a boost, though the benefit to Canadian miners and energy producers would be somewhat offset by the accompanied rise in the loonie relative to the greenback.

Such a development would also modestly dim the outlook for Canadian exports, though U.S. demand is the key factor driving the growth in shipments to our largest trading partner.

For equities, the historical relationship suggests a weakening greenback would give emerging market stocks (and the S&P/TSX composite index) better odds of outperforming the S&P 500.