One of the surprise global market developments over the past year has undoubtedly been weakness in the $US. Why? This note suggests that, rather than simply blaming a dovish Fed or an erratic US President, the main driver of $US weakness has been the broadening (or “synchronisation”) of global growth over the past year, which has encouraged investors to increase exposure to (at least up until recently) under performing non-US markets. If this is the case, it does also suggest the $US is not about to turn around anytime soon.
We can’t blame the Fed or Trump for $US Weakness
After surging by 30% between mid-2014 and end-2016, the $US Index fell 9.9% in 2017 and is already down a further 3.2% so far in 2018. Some suggest $US weakness reflects concerns over low US inflation and whether the Fed would be aggressive in raising interest rates. Another argument is that concern with the ability of US President Donald Trump to pass legislation is to blame. But neither argument seems to hold much water.
As regards the Fed, for example, the fact remains the Fed did eventually lift official interest rates three times last year – exactly as it said it would at the start of the year. As evident in the chart below, short-term interest rate differentials continued to move firmly in the $US’s favour in 2017. Despite this, the $US tended to fall.
*US 2-year bond yields less an equally-weighted average of German and Japanese 2-year bond yields.
It’s also hard to argue that Donald Trump is to blame. After all, President Trump did eventually manage to pass US tax cuts, which so far at least has not helped the $US all that much. And to the extent investors were concerned with the new US President, it did not stop US equity prices rising strongly. Indeed, the S&P 500 index returned 21.8% last year.
We can blame improving non-US economic prospects
What we need to remember, of course, is that currencies are a relative price: even if the US economy is doing well, its currency could still fall if other countries are doing (relatively) better. In this regard, the story of 2017 was not US economic strength per se, but rather the broadening in global growth to non-US regions such as Europe and Japan. As evident in the chart below, the International Monetary Fund substantially upgraded European and Japanese growth prospects through last year relative to those of the United States.
This is also evident in the fact the longer-term interest rate differentials did not continue to move strongly in favour of the $US last year, particularly compared to those in Europe. Indeed, since end-2016, German 10-year bond yields have increased by 20bps more than those in the US.
*US 10-year bond yields less an equally-weighted average of German and Japanese 10-year bond yields.
Another tell tale sign of shifting global investor interest is evident in the strength in emerging markets. As seen in the chart below, broad trends in the $US over the past decade or so have tended to be inversely correlated with the relative performance of emerging markets (i.e. when commodities and emerging markets are weak, the $US is strong and vice versa). The strong outperformance of the US equity market has tended to level off over the past year, which has also been associated with a topping out in $US strength.
In essence, to the extent the $US is a global safe haven and important source of funding when non-US investors become more active (and who then sell borrowed greenbacks to buy their own or other currencies to make investments), the persistent weakness of the $US is arguably reflective of the growing “risk-on” sentiment across the globe. US markets have had a great run, but global investors now appear to be betting that non-US markets will enjoy a period of catch-up performance.
$A and RBA Implications
In turn, this “risk-on” global environment also suggests the $A may remain under upward pressure against the $US for some time longer, especially if this is also associated with continued firm iron-ore prices. Although the Australian economy has been doing well of late, however, further strength in the $A would likely be unwelcome at the Reserve Bank. Along with persistent low inflation and a potentially delicate transition in the Sydney property market, there is an argument to be made against it moving to a “tightening bias” anytime soon.
Gaining short and long exposure to the $US
Investors wishing to express a view that the $US will fall further (at least against the $A) can do so through the BetaShares’ Fund AUDS, which provides magnified “long” exposure to the value of the Australian Dollar relative to the US Dollar. By contrast, investors wishing to express a view that the $US has already fallen too far and will tend to strengthen (at least against the $A) can do so through the BetaShares Fund’s USD or YANK, the latter of which provides magnified ‘long’ exposure to the value of the US Dollar relative to the Australian Dollar.
Note: Gearing magnifies gains and losses and may not be a suitable strategy for all investors.