USD: Pressurised by multitude of factors - BBH

In view of analysts at BBH, three significant developments prevented the dollar’s multiyear rally from continuing in 2017:  a decline in US rates, a rise in European rates, and the manoeuvring around the US debt ceiling.

Key Quotes

“At first, the dollar seemed to fall on market positioning. The persistence of the dollar’s rally and the narrative around it led to significant exposure. This is evident from the speculative positioning in the futures market and the bullish sentiment found on numerous metrics and behaviors, such as the bouts of profit-taking, or buying the rumor and selling the fact on the Fed’s hike. The same was true about the positioning in the 10-year Treasury note market. A record short position was accumulated by speculators in the first quarter.”

“However, then the data and the narrative changed. US economic data (activity as well as prices) disappointed investors. There was a growing sense that it would be difficult for the new US administration to deliver its legislative agenda.”

“The changing expectations for fiscal policy, the disappointing real sector activity, and soft core prices weighed on the dollar through the interest rate channel. Our work continues to show a robust correlation between the US dollar and interest rate differentials.”

“At the same time, European growth remained firm, and a combination of factors sparked a sharp increase in the national and aggregate CPI. Interest rates rose, and some hawks began testing the possibility that the negative 40 bp deposit rate is hiked before the asset purchases are complete.”

“The initial profit-taking at the start of the year turned into a rout. Disappointing US data, better European data, and doubts about the ability to implement Trump’s economic agenda, coupled with the real and unhedged flows into European equities and emerging markets, took a toll on the greenback. For the first time in three years, speculators in the CME futures were net long euro contracts, and the gross long position reached a record high in Q2.”

“There was another development that may seem technical but appears to have had a profound impact. In order to maneuver around the debt ceiling, Treasury Secretary Mnuchin took measures that resulted in around $400 bln of liquidity being injected into the financial system.”

“This relieved the shortage of dollars that was evident in the dollar’s appreciation in the spot market and the extreme premium for dollars in the cross-currency swaps market, an important institutional market. A key takeaway from this is that when the debt ceiling is raised – and at some point, it will be – liquidity will be withdrawn, and, of course, depending on what else is happening at the time, that would be favorable for the dollar.”

“While recognizing the tactical demands, we are reluctant to abandon our strategic constructive view of the dollar at this juncture. Divergence, which shaped our strategic thinking, continues.”