It’s all relative
For King, the way forward is less about the diverging path of interest rates and more about relative growth rates.
“The US economy is likely to strengthen further this year, but we also think there will be a pick-up in growth in Japan and Europe – and maybe even the UK – and the decline in the US’s relative growth advantage is likely to lead to some weakening in the dollar.”
However, he adds: “We don’t think the Japanese or European central banks are particularly keen to see their currency strengthening, so if you saw the euro going up quite sharply against the dollar, for example, you might expect another move by the ECB as you saw late last year to effectively inject liquidity and knock the currency back a bit.”
Batten agrees, saying: “It has been easy to talk about dollar strength in broad terms over the past two years as it has appreciated against every other currency. This year we expect a significant amount of diversity within the broad dollar basket.
“Several countries have significant structural problems: sterling has to cope with a sizable current account deficit, a Brexit vote and a fiscal retrenchment, while the Australian dollar and New Zealand dollar continue to look expensive versus their main exports and vulnerable to further negative China news.”
Three strikes and you’re out
For David Absolon, investment director at Heartwood Investment Management, there are three strikes against the view that the dollar can sustain its sharp upward path.
The first of these, he says, is the sheer strength of the move already seen both in isolation and on a trade-weighted basis. The second is that, given the level of consensus within the market, being long the dollar is a very crowded trade. The third strike is that the macro data on which much of the belief in dollar strength was predicated, has softened somewhat, leading investors to question the Fed’s ability to follow through on its plans for further rate hikes this year.
“Should the Fed backtrack on its intentions, you could even see the dollar weaken,” Absolon says.
There are also technical arguments against further major moves in the currency. As Axa Investment Managers’ senior international economist Laurent Clavel pointed out in a recent note, while monetary policy divergence should result in dollar appreciation, FX models based on interest rate differentials have little predictive power, because they not only already price in monetary divergences but also have a tendency to summarise more than just interest rate differentials.
According to Clavel, the dollar is currently overvalued by more than 10% against the euro in terms of purchasing power parity. But he adds that, while PPP works well in the long run, “the PPP mean-reversion force is so weak that it is generally rejected by standard statistical tests”.
“More specifically, ECB 2016 finds that the further away the real exchange rate moves from PPP, the stronger the adjustment intensity becomes.
“For large deviations from PPP, the implied half-life of adjustment, which measures how long it takes for the effect of a shock to halve, is two to three-quarters, compared with an average mean-reverting half-life of three to five.
“In short, the dollar could stay overvalued for some time but, with already a significant deviation from PPP fair value, the depreciation pressure is slowly building up.”
