We view the direction of the U.S. dollar as the most pressing question in foreign exchange markets as the world’s most important currency sways the outlook for emerging markets (EM) equity and debt, two of our preferred asset classes. After the trade-weighted dollar index (DXY) rose more than 5% from April 6 to May 29 to reach 94.8, it has failed since to breach the 95 level, as shown in the chart below.
USD index (DXY)
Assessing the bull and bear cases from the perspective of our cycle-valuation-sentiment investment decision-making framework, we retain an overall neutral view on the U.S. dollar.
- Business cycle: It remains slightly positive for the U.S. dollar, but finely balanced between supportive and negative factors. While we see the interest rate differential and recent positive economic data as strong tailwinds for the dollar, the market has already priced in future interest rate increases. On the other hand, deficits in the U.S. federal budget and the current account are weaknesses that could weigh on the dollar in the medium term.
- Valuation: The U.S. dollar is expensive. The real effective exchange rate suggests that the greenback is around 10% overvalued against a basket of developed market currencies. This is corroborated by the deviation of the dollar exchange rate from its purchasing power parity (PPP) level against the euro, the Japanese yen and the British pound. Against all three of these major currencies, the U.S. dollar is overvalued on a PPP basis.
- Sentiment: This is neutral. Momentum has improved and swung from negative to neutral. One-sided positioning was an important driver of recent USD strength. Speculative investors had a very large net dollar short at the beginning of 2018, but have since sharply cut that bet, thereby pushing the greenback higher. With a smaller short position outstanding, the risk that the dollar uptick continues has diminished.
As the U.S. dollar runs out of steam, we believe that investors in EM assets do not have to head for the exits.
Other major currencies
- Euro (EUR): It took Italy until late May, a brush with constitutional crisis, and the prospect of new elections to force the formation of a government. The single European currency was weighed down heavily by the political uncertainty, with the EUR/USD exchange rate dropping close to 1.15 before recovering. Cheap valuation, a healthy current account surplus and the expected gradual exit from the ECB’s loose monetary policy keep us constructive on the euro.
- Japanese yen (JPY): The yen is still our favorite G10 currency based on its attractive value and safe-haven characteristics. While inflation has recently softened and the Bank of Japan is in no hurry to abandon its yield curve control policy, we view JPY as a cheap diversifying asset during times of potential turbulence.
- UK pound sterling (GBP): A toxic combination of very soggy economic data and rising discord within the UK government around its Brexit strategy conspired to drive the pound lower in Q2. With the GBP/USD exchange rate around 1.34, sterling is now at a valuation discount that prices the political risks surrounding the Brexit negotiation appropriately. We believe the pound could find a floor at current levels.