The greenback in a surprisingly move
At the beginning of this year, I argued that the dollar would gain six to seven pct. against the euro in 2016 reaching 1,0250. Since then, the greenback steadily has lost in value and thus moving in the exact opposite direction of my prediction. This is of course a good reason to rethink the whole situation. I admit that new burdensome factors emerged for the dollar during the first quarter, and these were fair arguments for selling the USD lower.
This year’s disastrous start for the stock market naturally had an impact on the currency market where the dollar takes a center stage position. The financial markets were dominated by fear where the United States and thus the dollar in the past would be a “flight-to-safety” destination. But that’s history because investors will tend to increase the cash position during a crisis. Decades ago the United States was the world’s largest creditor nation. Therefore the dollar rose during a crisis because American investors reduced foreign investments and moved the capital back home to their base currency.
In my view, the foreign exchange market is exploring these “crisis moves” from time to time like in the first quarter. Quite interesting the yen has been a getaway currency several times since the financial crisis. The same tendency could be observed this first quarter where yen gained around 10 pct. against the greenback. I do not exclude that there will be more turbulence in the equity markets this year and it is a risk factor that can hurt the dollar throughout 2016. The reason why the greenback has become more vulnerable compared to decades ago, is simply that the U.S. now is a huge debt nation instead of being the biggest creditor nation in the world.
INTEREST RATE IS CRUCIAL FOR USD
Even the Fed contributed with a good deal of confusion by being uncertain about their own faith in the American economy. When Fed raised interest rates on December 16th last year a widespread belief in four additional rate hikes during 2016 quickly occurred in the financial markets. Although I have steadily considered two hikes for realistic which currently also seems to be a consensus among most market participants. But I believe that the swings in the rate hike expectations weighted on the dollar during the recent months as the trust in four hikes became too dominant during a short period.
When I rebalance my expectation to EUR/USD I always include the difference between 10-year yields in the U.S. and Europe, especially German yields, in my considerations. One of my arguments for a rising dollar against the euro was precisely the prospect of a widening of the 10-year yield spread in favor of the dollar.
Graphic one shows the differences in 10-year interest rates (10-year U.S. and German government debt), inflation, and real interest rates. Clearly, the difference in the 10-year rate has been increasing since the start of 2014, which I still regard as an advantage for the dollar. But it is of course not unimportant how the real interest rates develop. The increase in the USD from spring 2014 and about one year ahead shown in graphic two is synchronous with the rise in real interest rates to the greenback’s advantage.
During that period other significant changes took place as well-meaning that I of course don’t explain currency moves by interest rate differentials only. A clear European verbal intervention against the high euro happened back in 2014. In addition, the U.S. economic growth was in much better shape and still is, plus there was greater uncertainty about the future of the euro.
But, during this first quarter real interest rates in favor of the dollar narrowed sharply, and at the same time, the USD came under pressure. I give these changes a certain weight in my EUR/USD view though the reason for the decrease in the real interest rate spread was a growing U.S. inflation during the first quarter. Many economists still forecast even higher inflation in the U.S. which can narrow the difference in real interest rates further and, ironically, weaken the greenback again. In my judgment, the U.S. inflation, therefore, means more for the dollar direction than normal. The two rate hikes from Fed are already priced in the market and Fed can’t hike more unless the GDP growth increases suddenly, which is unlikely. Where I have a contradictory view compared to the market is that I don’t see any source for inflation in the U.S. meaning inflation will flatten instead of rising more. My scenario is as a consequence that the real interest rate rises in favor of the greenback again this year.
A DIVIDED FINANCIAL MARKET
I estimate that the economic growth will affect the EUR/USD exchange rate more during the rest of 2016 than it has been the case during the past 12 months. What surprised me lately is how divided the financial market is when it comes to U. S. GDP growth expectations. In February I spoke at a conference in Miami and I was very surprised. A large share of the participating American pension funds and asset managers actually expected a declining dollar rate this year. Precisely at that time, Fed expressed thoughts about a 20 pct. risk of recession in the U.S. in 2017, but a number of large banks even work with this outcome as the main scenario.
Should this really be the case then I would have to reassess my upbeat dollar view. The negative outlooks concerning the dollar that I have met during the first quarter have exclusively been based on an isolated dollar expectation without taking the euro outlook into account. Apparently, the majority in the financial markets had a belief in a higher GDP growth in the Eurozone this year which results in natural comfort. But I maintain my strong trust in a disappointing Eurozone growth in 2016 which will weaken the euro. Increasing risk is that a weaker euro even could be initiated by the European Central Bank (ECB) if the economic growth desperation at the central bank rises further.
In total, I currently keep my main view that interest rates finally support the greenback during 2016. In addition, weaker economic growth in the Eurozone will soon play a role in the foreign exchange market. And very basic, I regard the dollar as pretty robust as many new factors from the first quarter are negative for the dollar. Still, the greenback lost only four pct. against the euro during that period but it would have been much more if the majority of the market really had doubt in the dollar. It does not change that my assessment from the beginning of the year has been wrong. The dollar now has to increase by about 10 pct. to reach my target for this year – it remains my assessment.
