Weekly Bond Bulletin: Demystifying the dollar move? - J.P. Morgan Asset Management
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Weekly Bond Bulletin: Demystifying the dollar move?

Contributor GFICC Investors

Despite positive rate differentials, the dollar’s meaningful decline has continued into the New Year. With no single culprit identifying itself, several factors may be contributing to the US currency’s ongoing weakness.

Fundamentals

US data releases over the week continued their strong trend, including upward revisions to retail sales and a robust fourth-quarter GDP forecast from the New York Fed of 3.9% year-on-year. Notably, the missing piece of the macroeconomic jigsaw—inflation—showed a meaningful rebound: December’s core consumer price index surprised to the upside, up 1.8% year-on-year, compared to an expected 1.7% increase. Moreover, the report indicated improvement in both the goods and services components. Theoretically, these measures should lead to a strengthening of the US dollar, although importantly the US is not growing in isolation. In the eurozone, industrial production registered an elevated 3.3% rise in November and there were upward revisions to the previous month. Furthermore, our internal quantitative indicators suggest that European economic data continues to surprise meaningfully to the upside.

Quantitative valuations

After depreciating 7% on a trade-weighted basis in 2017, the US dollar has declined a further 1.6% so far this year (through 17 January). What is driving this sharp move lower? Higher rates in the US vs. the rest of the world would seem to justify a stronger US dollar, given the relatively attractive carry profile, though this is being trumped by a combination of other factors. The initial currency move was attributed to the press story regarding a reduction in, or halt to, Chinese purchasing of US Treasuries—although this has since been viewed as more of a political warning sign than an actual investment intention. Another reason could be the rise in energy prices, although we believe the US dollar is less sensitive to oil since the shale boom in recent years. The most valid explanation in our view is a rotation in equity market flows in favour of the euro over the US dollar, a trend we saw emerge last year, though there is little hard data to evidence recent buying.

Unhedged equity flows in favour of Europe could be driving recent US dollar weakness

Source: J.P. Morgan Asset Management, Bloomberg; data as of 15 January 2018.

Technicals

While it is unlikely that investor positioning triggered the US dollar weakness, it is possible that it has led to some capitulation in the move. Key technical levels broke this week amid high volumes, resulting in the EUR/USD moving from 1.20 at year end to 1.22 as at 17 January—a level not seen in over three years. As currency investors, particularly fast money hedge funds, stop out of their long US dollar positions, the subsequent selling has put further downside pressure on the currency.

What does this mean for fixed income investors?

Going into 2018, our view was that the US dollar would weaken vs. the euro over the course of the year, but appreciate in the near term due to its “high yield” status compared to other developed market currencies. However, the US dollar has been astoundingly divorced from rates spreads. As we struggle to identify a single justification for the recent US dollar weakness, it seems that it may be a matter of many small moving parts accounting for the currency move. We maintain our view of a higher EUR/USD by year end, though we recognise that much of this move has happened more quickly than we anticipated. As such, we have a neutral EUR/USD position and instead are expressing our positive euro view by going long euro-related currencies vs. short exposure to commodity-bloc currencies, such as the New Zealand dollar.


About the Bond Bulletin

Each week J.P. Morgan Asset Management’s Global Fixed Income, Currency and Commodities group reviews key issues for bond investors through the lens of its common Fundamental, Quantitative Valuation and Technical (FQT) research framework.

Click here   to read more about our FQT capabilities.


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