the thin line between consensus and catastrophe

Tuesdays announcement by the Office of National Statistics that UK inflation fell to zero in February underlined, not only that rates are unlikely to move higher anytime soon, but also just how quickly consensus can change.

the thin line between consensus and catastrophe

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Last summer, for example, some of the more bullish market commentators were calling for the first hike of UK rates since 2009 to come in November. With this in mind, a recent note by HSBC calling into question the longevity of the dollar bull market made for particularly interesting reading – especially in light of last week’s slump in the currency.

In a note out last week, the firm’s global research team said it believes the dollar rally is “coming to an end”.

Despite a market that “appears determined to envisage ever greater upside for the currency,” it points out, “The USD has already rallied more than is typical historically, and many of the arguments currently being used to justify an extension are likely already in the price.”

While admitting that there remains scope for a final spike higher, the firm believes it is time to start looking the other way, forecasting the EUR-USD rate will be 1.10 by year-end 2016, compared to 1.05 previously. It expects the rate will move to 1.20 during 2017.

“Clearly there are events such as EUR break-up or JPY debasement which could lead to destructive dollar strength. But these are very much tail risks and we believe it would be a mistake to be drawn into the forecasting fashion of relentless dollar dominance.”

As justification for this view, HSBC points to a number of factors. First among them is history. Excluding the “mega-rallies of the early 1980s and mid-1990s,” it writes, “the average dollar rally has been roughly 20% based on the DXY index, and has lasted just under a year.”

This is in sharp contrast to the current move, which has seen the dollar rise over 25% since June last year alone.

The second point made is that the continued course of monetary divergence is, in its view, already in the price.

“There may be a debate over the timing of the first Fed hike, but the market generally accepts that it will happen this year, and that rates will move up only slowly thereafter… The drama offered by policy divergence has already run its course. The dollar rally will stall as the market demands “tell me something I don’t know” the bank writes.

Third point made by the bank is that, while the US economy may outpace others in G10, “the disappointing data on activity are mounting and are being ignored.”

It added: “US inflation remains shy of target. Policymaker tolerance for strength will not be limitless. At the same time, the Eurozone economy is beginning to deliver frequent upside surprises on activity, also being ignored by the FX markets. The recalibration of growth expectations could become euro positive. In addition, valuations show the USD is nearly the world’s most overvalued currency, outdone only by the swiss franc.”

However, the bank does point to a set of circumstances under which the dollar could continue to strengthen, but were they to occur, they would point to a” destructive dollar surge rather than the generally benevolent one we have seen so far.”

Were Japan’s policymakers to lose control, or the eurozone to break up or were there an emerging market currency crisis, the dollar would strengthen, but these should be considered tail risks rather than reasons to remain positioned for dollar strength.

Roger Hallem currency chief investment officer within JP Morgan’s global fixed income group is in the opposite camp, but told Portfolio Adviser that last week’s data shouldn’t be dismissed.

“One could see a slowdown in the rate of appreciation,” he said, “We believe we are seeing a soft patch in the data, but we are still broadly optimistic that final domestic demand should remain largely robust and that the Fed remains on track to hike rates in September.” 

He added: “The take away from last week’s data, and the reaction to it is, we really are now completely data dependent.”

Natixis agrees, pointing out in a note: “From now on, everything will depend on the next macroeconomic indicators.

“So far this year, they have been rather disappointing, but growth is expected to remain solid at around 2.9% in 2015. In particular, the labour market is still very upbeat,” it said.

But, it added: “Bearing in mind the central bank has lowered its unemployment rate projection to 5.0%-5.2% (a level that would be expected to generate wage growth), a more significant decline in the unemployment rate from 5.5% currently would heighten expectations of an interest rate cut, although obviously the Federal Reserve is seeking to keep a lid on market expectations.”

Nick Sketch, senior investment director at Investec Wealth and Investment also does not expect the dollar consensus to be proved wrong this year, but agrees that such an event cannot be ruled out.
“If it happens, a lot of us could be holding UK stocks that suffer, and the implications for what must have gone right outside the US means that investors will, at the very least, want to ensure that some of their investments are outside the bucket labelled ‘strong-dollar-beneficiaries’.”

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