The direction of the US dollar is one of the most discussed topics for investors today, and with good reason. Ugo Lancioni (pictured below) looks at its longer term prospects.
Longer term, we believe the dollar is close to fair value – if not slightly overvalued – and is on a downward trend. This view is supported by purchasing power parity and the negative sentiment associated with the US’ twin deficits, caused by aggressive fiscal expansion, which will demand foreign financing.
Nonetheless, we have a cautiously positive near-term dollar outlook. This reflects the view these long-term dynamics, in combination with changes to central bank balance sheets and perceived US political risk, have pushed the currency too low already – especially given the countervailing trend of US interest rate divergence with the rest of the world.
Dollar selling, both speculative and related to unhedged equity flows toward Europe, has persisted despite the fact interest rate differentials have widened dramatically in favour of the US currency, up to about 3% per year. It is likely euro and yen-based investors will begin to question holding currency-hedged US assets at a cost of 3% per year.
By the same token, US dollar-based investors will eventually notice the ability to earn 3% per year by holding currency-hedged European assets. Therefore, the incentive to reverse recent flows out of the dollar are building. The recent rise in the US dollar overnight index swap rate also suggests demand for dollars may be picking up.
The short-term nature of our strong-dollar view also helps to explain how our Asset Allocation Committee can upgrade its dollar outlook, without revising the overweight view on emerging market equities and debt. As well as acknowledging global investors are still underweight emerging markets – which are much earlier into the recovery than developed markets – we regard the long-term downtrend in the dollar as a net-positive for the emerging world.
Neuberger Berman’s key global currency calls
USD: Overweight. Market participants are short the dollar, but short-term yield differentials are supportive and US economic data surprises have improved. Excess weakness this year may be due to one-off flows. Risks to the view include softer than expected inflation, the fact the dollar is moderately overvalued on a long-term PPP basis and that Fed tightening is already largely priced in.
Euro: Underweight. The strong euro is causing a tightening of financial conditions and ECB monetary policy will continue to be accommodative as inflationary pressures are weak and have surprised on the downside, as have PMIs. The political situation in Italy may be unstable for some time. Risks to the view include a more relaxed stance from the ECB on the growth outlook, as forward-looking indicators still suggest above-trend growth for 2018. The eurozone also boasts a large current account surplus.
Yen: Neutral, from a slight Overweight. However, we retain a more favourable view on a three to six-month horizon. Japanese growth remains solid and inflationary pressures are starting to build and there are tentative signs the BoJ is preparing the market for reduced stimulus. Long yen also remains a valid trade during periods of risk aversion and Japan has a strong current account surplus. Market participants are short yen, despite PPP and real exchange rates suggesting the currency is undervalued. Downside risks include the wide yield differentials, the continued low inflation in Japan and the fact the yen is already the best performing major currency this year.
GBP: Neutral, from a slight Overweight. Similar to the yen, we retain a more favourable on sterling over a three to six-month horizon. The GBP is undervalued based on PPP measures and a rate hike from the BoE has narrowed yield differentials. Job creation and wages have been stronger than expected and progress has been made in Brexit negotiations. Downside risks include a return to political uncertainty, as Brexit negotiations move into the details, lower consumer spending power and a weak GBP importing inflation and causing real yield erosion.
Swiss Franc: Underweight. The franc is still very overvalued based on PPP measures, which is keeping inflation low. Safe haven flows should continue to be unwound, as European prospects improve and the SNB will likely lean against any rapid appreciation. Risks to the view include Italian political uncertainty, Switzerland’s strong current account balance and a potential uptick in the country’s inflation dynamics.