The most important theme of this week’s trading has been the sharp selloff in the US dollar. The dollar has been the favorite currency for traders to be long of since the first half of 2014. The dollar index, which measures the value of the greenback against a basket of 6 major currencies (the euro makes up more than half the basket), has fallen by more than 4% since the beginning of February. The index is currently at 95.80.
Although the index has stayed above the 93-94 area, which is a crucial level whose violation may negate the 1 ½ -year uptrend, there are many that worry that the global financial turmoil could also mark the beginning of the end of the dollar bull-market.
It is perhaps worth remembering at this point that currencies cannot only go up or down; they can also stay within ranges and not move much for prolonged periods of time. Since peaking above 100 in March of 2015, the dollar index has more or less marked time; moving in the rough 94-100 range. The dollar rally ‘stalled’ back then as it became evident that the Fed would not hike rates as quickly as some expected. The eventual rate rise in December of 2015 helped the dollar index to rally once again up to the 99-100 level but in the past couple of weeks there was the sharp selloff that has brought it back down.
The explanation for this change of heart lies with the deteriorating prospects of further interest rate hikes. Please note that the big move in the US dollar during the second half of 2014 and the first quarter of 2015 was driven by expectations of policy divergence; mainly that the Fed would be raising rates while other major central banks such as the ECB and the Bank of Japan would be loosening policy. Following the market turmoil since the beginning of the year and the possibility that the Fed is going to stay on hold for the next few months, holding dollars has become less attractive, even if the ECB and the Bank of Japan are still expected to loosen policy more.
For expectations of medium-term monetary policy, one can turn to the 2-Year Treasury yield (purple line). On December 29, 2015, the 2-year yield climbed to as high as 1.09%, whereas more recently, the yield has crashed down to 0.64% - the level at which it was trading late last year before the Fed rate hike and before it was made clear rates would go up in December.
This week’s testimony by Fed Chair Janet Yellen was a balancing act in which she sought on the one hand to reassure investors that the US economy was on track, but also to let financial markets know that the Fed is paying attention to the effects of the turmoil and that it was monitoring the situation. Markets made an aggressive interpretation of these statements by greatly lowering the chances of any rate hikes this year in the United States. Therefore the likelihood of stable rates during the remainder of the year could represent a very significant obstacle to dollar bulls.
The second major obstacle that dollar bulls could face could be from the safe haven trade. The euro and the yen, the US dollar’s two most competitors, are also considered safe havens because of their status as funding currencies. The market has tended to bid the two currencies higher when there is turmoil as many investors used the low-yielding euro and yen, two economies where Quantitative Easing is still taking place combined with negative rates, in order to fund riskier bets. As the Bank of Japan’s failed attempt to guide the yen lower through the use of negative rates showed, getting rid of the safe haven attributes of the yen is not so easy. Again, dollar bulls may have a problem overcoming safe haven flows, which will help currencies such as the yen and to a lesser extent the euro or the Swiss franc to rise against the greenback.
To sum up, there are two important obstacles for a higher US dollar; the possibility of stable US rates and safe haven flows. At the same time it will be surprising if the market turns so aggressively against the dollar that it breaks lower from its 93-100 range. That would take a reassessment of US monetary policy that would lead to rate cuts and perhaps additional unconventional monetary action. It is far too early to contemplate such a possibility given also the latest decent numbers out of the US economy.