Why the dollar will continue to weaken in 2018

The US dollar, traditionally a safe-haven currency in volatile times, has been trading at near multi-year lows.

Fixed income specialist Michalis Ditsas and co-head of multi-asset at SYZ Asset Management Fabrizio Quirighetti predict the dollar will weaken in the second half of the year, with a target of 1.30 against the euro by the end of 2018.

The Federal Reserve’s path to tighter financial conditions is now largely priced-in by the markets, they say.

Where both the eurozone and Japan have current account surpluses of around 3% of their gross domestic product, economic fundamentals point to a phase of euro – and eventually yen – strengthening against the dollar.

US president Donald Trump’s announcement of the introduction of import taxes on steel and aluminium also adds to driving down the dollar.

The cost of hedging is another significant factor. Hedging US dollar risk has increased meaningfully since the last quarter of 2017, which makes investments in US treasuries by European or Japanese investors costly.

European and Japanese investors were directed towards buying US treasuries due to the negative yields in their domestic government markets, while at the same time adding to portfolio diversification.

The European Central Bank (ECB) and Bank of Japan government bond purchases were above net issuance, which is the absolute amount of bond issuance less the absolute amount of bond redemptions for the same period.

This forced domestic buyers of government bonds to increase their exposure to foreign bonds, essentially US treasuries.

Normalisation from the ECB could apply upward pressure on European rates and strengthen the currency.

Ditsas and Quirighetti say that valuations of the European and Japanese equity markets are less strained than those of the US market and their growth potential appears to be greater given the stages of their economic cycle. This stock market dynamic – and its effect on investor demand for US dollar-priced stocks – creates a further headwind.

This is not the only Trump ‘America First’ rhetoric that is affecting the dollar trajectory. In addition, the US tax reform indicates an increase of fiscal deficits, which historically has tended to weaken the dollar.

Assuming a continuation of synchronised global growth and normalisation of monetary policies in Europe and Japan, the financial flows that have supported the dollar in recent years should reverse.

China is not allowing the value of the renminbi to fall, as Beijing worries about being accused of currency manipulation. At the same time, the People’s Bank of China is not buying as many US treasuries as it usually does.

©2018 funds europe

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