A Dollar That Stays Within the Lines

A range-bound U.S. dollar could contribute to a renewed focus on company and sector fundamentals

As I look back at some of the comments made in CIO Weekly Perspectives about our constructive views on non-U.S. equity markets, a key aspect of the story has been improvement in sentiment and growth fundamentals in various countries and regions around the world. Another crucial element in my view has been a shift in currency market dynamics.

Unlike in 2014 and the first half of 2015, the recent market price action has not featured a sustained rally in the U.S. dollar. Instead, we’ve seen a healthy correction in the dollar relative to other currencies including the euro and in particular the yen, with the Fed’s U.S. Trade Weighted Major Currency Dollar Index declining almost 7% during the first four months of the year.

Our general view is that this is a positive development. Especially in the U.S., earnings growth has been a cloud over the markets since the third quarter of last year. The absence of further dollar strength, coupled with firmer energy prices, may be setting the stage for a better earnings picture in the second half of the year.

Fundamental Reasons for Dollar Decline

A key question, however, is whether recent dollar weakness is justified. We believe the answer is yes, based on both the fundamentals and technical factors.

First, the fundamentals. Prior to the dollar correction that started in early February, pessimistic views prevailed regarding the trajectory of the global economy, but we’ve since seen improved sentiment on China as well as encouraging signs in Europe.

Then there’s central bank policy. Back in Q3 and Q4 of last year, the Federal Reserve seemed determined to execute multiple rate hikes in 2016. But in the midst of a soft patch in U.S. growth, they turned more dovish in Q1, to the point where markets anticipated just one—or at most two—rate increases this year.

Unlike in previous episodes, other central banks have not aggressively “played down” their currencies so far in 2016, effectively giving a green light for the dollar to correct lower. Earlier this year, the Bank of Japan and, to a lesser degree, the ECB seemed poised to move aggressively into negative rates territory. However, following the market’s hostile reaction to the BoJ’s January rate cut, central banks appear to be pursuing alternative, more tempered, policy options.

Finally, from a technical standpoint, we think the U.S. dollar bull market simply exhausted itself. So many strategists, from asset allocation gurus to FX experts, were still in the dollar-strength camp last year. Recently, they’ve changed their minds, piling into the short dollar trade versus the euro and yen.

Where We Stand

Although we acknowledge the reasons for the dollar decline, we’re not in the bearish camp at this point. Rather, we think the dollar is settling into a trading range that could last for the rest of the year and into 2017, driven by the factors I’ve mentioned—a healthier mix of growth dynamics and cautious central bank policy. Indeed, we’ve recently seen headlines about central banks disappointing markets in their “failure” to take action, and I think we’ll see a lot more of that, and fewer surprises from monetary policymakers.

Overall, we believe there are currently few drivers to justify a sustained breakout from current trading ranges. In terms of our views and given the more attractive levels, this translates into a tactical net-overweight dollar exposure and a modest short in the yen.

A connected issue relates to commodity-driven currencies. Since mid-January, the Canadian and Australian dollars have seen a strong recovery. Although we think there is fundamental justification (i.e., better Chinese data), the move is also largely technical in nature. A recent decision by the Australian central bank to ease rates is symptomatic of the underlying reality that Australia is not immune from global disinflationary pressures. Despite opinions to the contrary, in the near term we see limited potential for a new bull market in commodities or, by extension, commodity-driven currencies.

Smoother Ride? More Potential for Shocks

In this environment of subdued market drivers, there are risks. An obvious one is the potential for a vote for Britain to leave the EU late next month. While polling numbers are still implying a reasonable chance of Brexit, bookmakers now price only a 30% chance of separation. Sterling has been factoring in a high Brexit premium for some time but it recently rebounded to reflect lower Brexit probabilities.

A more subtle issue is posed by the subdued, range-bound environment. Without big differences in growth or drama from central banks, currency markets can become more technical in nature, and more vulnerable to shocks from exogenous events.

Circling back to where I started, how does all this affect risky financial assets? For much of 2016, we’ve been talking about the potential for better earnings in the absence of headwinds from the strong dollar or commodity weakness. Now that they are actually out of the way, and central banks are becoming quieter, we believe that the focus is likely to shift to individual company and sector fundamentals. Rather than dwelling on the macro, the challenge and potential could be far more extensive at the micro level.

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