The U.S. dollar is looking pretty good as the second quarter draws to a close, but don’t expect it to take all the trophies when 2018 comes to a close, a Pimco analyst warned.
The buck has strengthened this quarter, helped by a Federal Reserve that is marching ahead of other major central banks, steadily tightening monetary policy and building on the differential in interest rates between the U.S. and other economies.
Read: Here’s how the ECB just breathed new life into the dollar rally, analysts say
The ICE U.S. Dollar Index
DXY, +0.44%
, which measures the greenback against six rivals, most notably the euro
EURUSD, -0.4699%
, is up 2.6% in the year-to-date, after dropping some 10% in 2017.
But it’s unclear how long the U.S. economy can maintain momentum at what may be the late stage of the cycle, and at which point the dollar’s strength will serve to slow growth.
Check out: Some companies are already warning investors that a strong dollar will pinch performance
“Forecasting currency performance is like predicting the outcome of a horse race,” said Pimco global strategist Gene Frieda, in a note, likening the swings of exchange rates to horses moving up the field and falling back for idiosyncratic reasons.
The buck has established itself as the frontrunner in the currency race, in part thanks to the momentum in U.S. economic growth, as reflected in recent data. Still, winning the race “will likely prove elusive for the dollar in 2018,” Frieda argued, because it would need to prevail according to a trifecta — or Triple Crown, if you will — of factors: “superior valuation, highest carry and pre-eminent cyclical position.”
“The dollar won the currency Triple Crown in 1981 and again in 1996, when it was historically cheap, real and nominal interest rates were well above those of its peers, and U.S. growth was outperforming.”
Does that sound a bit like 2018? Not so fast, Frieda said.
Yes, U.S. growth is outpacing its peers and the Federal Reserve remains at the forefront of policy normalization among developed economies’ central banks, expected to lift interest rates up to twice more this year. So the buck is on track for two of three factors. But what about valuations?
“The dollar today is not cheap,” Frieda said, putting a dent in this perfect dollar story. “It is now in the 70th percentile based on valuations over the past 38 years.”
It’s a similar tune for the equity market, as “most cross-border equity flows are not currency-hedged,” Frieda said.
On top of that is the concern about how long [the U.S. economic] momentum can last,” Frieda said. Many market participants consider the economy in a late stage of the cycle, and fiscal stimulus propping up growth of late even as much of U.S. peers in the developed world experienced some sluggishness.
And the risk of an overheating economy is met with limited scope for fiscal stimulus to curb the next recession.
“Accordingly, U.S. medium-term bond yields are unlikely to rise much higher than those in peer countries absent a major inflation uptick,” Frieda wrote. “This should in turn constrain the dollar’s long-term yield advantage over other currencies,” he added, though this doesn’t mean the greenback will fall off a cliff either.
The U.S. 10-year Treasury bond
TMUBMUSD10Y, -0.16%
yielded 2.876% on Tuesday.
Read: Trade tensions will slow the Fed’s rate-hike path, solving a bond market conundrum
By 2019, other major central banks will begin catching up with the Fed and normalize rates, according to Frieda, narrowing the interest rate spread between the U.S. and its peers. This could lend the dollar’s rivals an advantage, as they will have more room to run just as the dollar did this quarter.
However, should eurozone growth, for example, remain sluggish, leading the European Central Bank to delay monetary policy normalization further and reinforcing the rates differential trade that favors the buck, the dollar’s rally could run for longer.
Similarly, though trade tensions aren’t really good for anybody, the dollar functions as a haven currency at times. If trade tensions continue to escalate, this could keep to buck on it’s upward track.
Check out: Here’s what currency traders should remember when dealing with geopolitical risk
Source : MTV
