Ahead of today's Federal Open Market Committee July minutes release, we look at the dollar from a more fundamental and broader perspective. In particular, I highlight the reasons why I believe that the time for true dollar strength is not quite here yet, despite all the tapering speculation and possible near-term USD - upmoves.
- Dollar smile theory and the current dollar behaviour
When it comes to judging the market action, I am a true believer of the saying “If it ain’t broke, don’t fix it”. In other words, as an analytical departure point, I accept the prevailing market pricing to reflect the true value of any given asset, regardless of what the longer term beliefs about it may be.In the context of broader dollar valuation, there is no disputing that the dollar is still in a weak cyclical stage that has prevailed since July 2012. This is clearly evident in EURUSD that has gradually been moving higher after hitting a multi-month low at that time.Below, I try to depict what in my view could set in motion actual real dollar strength in the markets again. To do so, we will use the The Dollar Smile Theory that was defined by a former currency strategist Stephen Jen. The general idea behind this theory is that the dollar at any given point in time is in one of the three stages of the so-called smile that directs its behaviour.The first part of the smile is where the dollar really outperforms and it does so when it benefits from broad and significant risk aversion that sees dollar-positive capital flows, given that the dollar is the main reserve currency and benefits from safe-haven status. This first stage was witnessed during the crisis in 2008 and it has replayed repeatedly since as we have seen rather large corrections in the equity markets and the USD being bid in tandem during those periods.The second part of the smile (the so-called bottom part) is when the US economy is showing at best modest signs of real growth potential and either low historical interest rates or possible expectations of future rate cuts, with the dollar exhibiting significant weakness. Finally, the third part of the smile is the stage of a scenario where the dollar is able to finally appreciate on strong GDP growth prospects and expectations of potential interest rate hikes.In our view, we are still sitting at the bottom part of the smile, that is to say we are still firmly in the second scenario. This would give a viable explanation as to why we are not seeing the dollar strength that most analysts continue to express and call on to materialise.So what can bring dollar strength back?
In our opinion, scenario three is not on the cards in the near term. Although the US economy has gradually entered a recovery path, strong trend growth accompanied with significant improvements in the labour markets are not quite here yet. From a yield outlook, despite all the monetary accommodation the Fed balance sheet expansion has resulted in since 2008, we are yet to see these translate into a major rise in inflationary expectations, which have remained rather stagnant for a long period of time. Though some pundits have been seeing potential hyper inflationary pressures on the horizon, we are clearly nowhere close to such scenarios.So for us to believe and to argue for true dollar strength, and staying within the smile theory framework, we would need to return back to the first part of the smile. In the medium term this would mean that the tapering that we potentially will see in the the Federal Reserve's September meeting, would result in a more serious shock translating into a combined sell-off in both US equities and Treasuries. Though these elements would be dollar-negative, they would likely be more than negated by global risk aversion and a reversal of capital flows.
This last scenario is certainly not unimaginable, but it still remains unlikely in my view, as I believe the markets will gradually digest the inevitable reduction in US monetary accommodation without necessarily being driven off the road altogether. Clearly, emerging markets have recently seen their share of risk aversion, but we have not seen this readily translating into an outright dollar buying frenzy.For the time being, in other words, I believe the dollar will trade in accordance to the second scenario and remain cyclically weak in the months to come.