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#Investments — 07.07.2017

Is The Dollar’s Upward Trend Coming To An End?

Guy Ertz

At A Glance
 

  • Dollar weakness seems overdone as we expect a recovery in economic indicators over the coming months. The euro has been benefiting from a renewed positive momentum since Mario Draghi’s comments.
  • The relative economic momentum has penalised the dollar. This seems overdone. We also think that the markets are underestimating the Republican Party’s ability to deliver regulatory and tax measures even if it will probably only be in the autumn.
  • The markets are still underestimating what the Fed will do in terms of policy normalisation while the opposite is true for the ECB outlook. This should lead to a gradual comeback of the dollar against the euro.
  • Key triggers for a strengthening of the dollar could either be a surprise decision by the Fed to announce a balance sheet reduction in July, or a rise in political (uncertainty over Italian politics) or geopolitical issues (North Korea).
  • We do not think that the dollar’s upward trend is coming to an end this year. We are confident that the US currency will rebound in the next few weeks and months. However, we have revised our 3-month target to 1.10. We keep our 12-month target at 1.05.
     

Normalisation Of The Economic Momentum And Central Bank Expectations

The economic surprise index has been falling in the US while stabilising in positive territory in Europe. As discussed in a previous note, such a gap is unusual. It reflects a normalisation after the initial excessive US confidence following the US presidential elections. We think that the recent negative economic momentum in the US compared with the eurozone will normalise over the coming months.

The Federal Reserve (Fed) hiked its target interest rate in June and reiterated its plan to continue increasing interest rates over the coming years. In our view, the markets are still underestimating the number of rate hikes the Fed will make in 2017 and 2018. We think the Fed could start a steady reduction of its balance sheet as early as this month. This is not expected by the markets and could accelerate the rise in US yields, thus pushing up the yield spread between the US and Europe.

On the other hand, we think that the markets may be overestimating the significance of a shift in the ECB’s message. Mr Draghi sounded more upbeat on the European economy, taken as a sign of a quicker normalisation of monetary policy. We assume that the ECB is still months away from hiking the refi rate. We expect the ECB to announce a reduction in the asset purchases in late Q3, with effect from January 2018. The next steps would be to end the QE, probably in mid-2018.

It is thus very likely that the markets will review their expectations for future central bank rates and thus for the difference between bond yields over the coming months. This should trigger a gradual comeback of the dollar against the euro.


Triggers For A Dollar Comeback And Concluding Remarks

Key triggers for a strengthening of the dollar could either be a surprise decision by the Fed to announce a balance sheet reduction in July, or a rise in political (uncertainty over Italian politics) or geopolitical issues (North Korea).

The euro reached overbought levels against the dollar a few days ago based on the Relative Strength Index. Another indicator of excess is that he market has built a large “short” position (speculative positions betting on a fall in the currency) on the USD and a large long position (speculative positions betting on a rise in the currency) on the euro. This suggests some normalisation ahead.

In terms of technical analysis, a correction is expected and the 50-day moving average will be the first key support level at approximately 1.11 (value of 1 euro).

We do not think that the upward trend in the dollar will end this year. We are confident that the US currency will rebound in the next few weeks and months. However, we have revised our 3-month target to 1.10. We keep our 12-month target at 1.05.


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