Dollar is on a strong depreciation path - Westpac

Analysts at Westpac explained that the USD has started the year right where it left 2017 – on a strong depreciation path. 

Key Quotes:

"We expected more fertile conditions for the USD to prevail, notably, for yield spreads to continue to broadly trend in the USD’s favour as tax cuts and easy financial conditions underwrite solid near term growth outcomes. Base effects from last year’s low US inflation prints start to drop out of the annual calculations from March 2018 onward too. That, along with upcoming Italian elections in March should have provided the USD with more support at the start of the year.

Thereafter our baseline scenario has been for a weaker USD in 2018H2. By mid-2018 mid-term US election fever will take hold and markets will be confronted by the risk of a Democrat party sweep of Congress and some clawing back of Trump’s pro-growth agenda. At this point the Fed will be confronted with a major challenge too - a probable ongoing shortfall in inflation at a time when Fed Funds will have for all intent and purposes have reached “neutral” (currently estimated  at 0% for real Fed Funds).

The USD may yet stabilise in Q1. The BoJ (23 Jan) could push back more forcefully against the hawkish read of their decision to cut long-term bond purchases while the ECB (25 Jan) could also push back against the hawkish read of last week’s ECB minutes.

At this point some might reasonably ask whether “extreme undervaluation” could potentially save the day and provide some USD support too? The short answer is “no”.

Slide one shows the DXY’s valuation against 2 and 10yr yield spreads. The USD is indeed “cheap” to yield spreads. Using five year rolling regressions the DXY is about 13% undervalued against 2yr spreads and 8% undervalued against 10yr spreads. But, that is not unprecedented. In 2005 the USD traded more than 20% cheap to yield spreads.

Slide two shows the evolution of the broad USD TWI around the last five Fed tightening cycles. On average the USD has typically appreciated by about 8% two years into the last five Fed hike cycles. Against that the broad USD has depreciated by almost 2% in the two years since this tightening cycle began. The USD thus seems to be lagging trends that typically prevail during Fed tightening cycles.

There is a major caveat however. As slide two shows the USD was exceptionally strong in the lead up to the first Fed hike in Dec 2015. In the two years into that first hike the broad USD TWI rose 18.2%. That is a substantially stronger appreciation profile than is typically seen going into a tightening cycle - over the last five cycles the broad USD rose a more “modest” 8% in the two year period going into the first hike. The USD’s underwhelming price action since hikes began may simply be payback for exceptional outperformance in the two years going into the tightening cycle. Adjusting for that the USD sits right in line with historical patterns around Fed tightenings.

In short, neither undervaluation versus yield spreads nor comparisons with past Fed hike cycles suggest that the USD is at an extreme undervaluation yet."