Is the Dollar Bull Market Over?

Even in the fast-changing world of foreign exchange, investors have been able to count on one thing for the last two years – that the interest rate policies of central banks would be the primary driver of currency movements. The so-called divergence trade hinged on the Federal Reserve’s tightening bias relative to the easing bias of the European Central Bank and Bank of Japan and was a fairly reliable organizing principle for foreign-exchange investors. On a trade-weighted basis, the greenback strengthened some 19.3 percent between mid-2014 and January 2016.   Just a few months after the Federal Reserve’s first interest rate hike in nine years, however, the rule has been flipped on its head. With the Bank of Japan and European Central Bank still in easing mode, Credit Suisse’s foreign exchange analysts are actually calling for the dollar to weaken against the euro over the next three months, and against the yen and currencies in non-Japan Asia, Eastern Europe, the Middle East, and Africa over the coming year. On a trade-weighted basis, Credit Suisse expects the dollar to decline 1 percent in the next three months.   Part of the reason for the recent dollar slump – the greenback is down 4.4 percent on a trade-weighted basis since the beginning of the year – is that central bank chiefs no longer seem to be convincing investors that they can achieve their goals of raising inflation, according to Credit Suisse foreign exchange analysts. While monetary easing announcements have successfully pushed down interest rates in Japan and Europe, they have failed to weaken currencies significantly.   Indeed, as often as otherwise, they have been accompanied by the opposite: Since the European Central Bank eased on March 10, pushing interest rates further into negative territory and announcing a second long-term refinancing operation for commercial banks, the dollar has weakened 2 against the euro. The dollar has also weakened 5 percent against the yen since the Bank of Japan announced negative interest rates on January 29. The trade-weighted dollar index is now 4 percent below its January 20 high and 1 percent lower than last year.   Meanwhile, the Federal Reserve struck an unexpectedly dovish tone at its March meeting, and with a British referendum on staying in the European Union coming up in June and a particularly turbulent presidential election season in the United States, Credit Suisse analysts doubt that the messaging will get more hawkish anytime soon. The bank’s house view is that the Federal Open Market Committee will not raise rates again until at least September, putting further downward pressure on the greenback. Instead of divergence, central bank policies are converging in a dovish direction. Meanwhile, U.S. election-related political risks pose an independent threat to dollar strength – Credit Suisse foreign exchange analysts have dubbed the possibility of a Donald J. Trump presidency “Trumpxit risk.”   Furthermore, the European Central Bank’s decision to keep rate cuts minimal and introduce a rather generous lending facility to commercial banks – those that increase lending by a certain margin will actually get paid to borrow from the ECB – should ultimately be positive for the European economy, and by extension, European assets. ECB President Mario Draghi provided another boost when he suggested that the bank would not cut interest rates further in the near future, reassuring investors that currency weakness was not the central bank’s primary goal. “We think the combination of measures is more likely to attract foreign investors to European assets than it will entice European investors to buy more foreign assets,” Credit Suisse’s FX analysts write in a recent report.   As for the yen, opinion polls suggest that the Japanese people don’t place much faith in negative interest rates, and the tough questioning of Bank of Japan Governor Harihiko Kuroda in the Diet suggests that lawmakers are wary of the policy too. in negative interest rates, and the tough questioning Bank of Japan Governor Harihiko Kuroda has recently undergone in the Diet suggests that lawmakers are wary of the policy, too. That may well curb any instinct for further forays into negative territory. Credit Suisse also suggests that as political risks mount in the U.S. and U.K., global investors could turn to the yen as a preferred safe haven as they did when China fears were running high in January.   In the longer term, the Federal Reserve is likely to begin hiking interest rates again in the second half of this year. Core inflation is rising toward the Fed’s 2 percent target rate, job growth has steadily improved, and investor risk appetite is recovering from panic levels earlier this year. Credit Suisse expects the dollar to rally some 3 percent on a trade-weighted basis over the next 12 months. The divergence trade may be on hold for the next three months, but over the longer-term, the trade is still on.