14 January 2021
While higher US growth expectations may provide a short-term boost to the dollar against some currencies, the US currency’s fundamentals remain challenging longer term.
The first weeks of 2021 have seen significant developments in the US growth outlook. Following the Democrat victories in the Georgia Senate races, expectations for growth over the next 12 months have been revised up by around 2% to around 6% year-on-year. The key focus for the market is now the extent of the fiscal package delivered by the new administration, widely expected to be significant. Also, while Covid infections are higher than in Europe, the US has not locked down to the same extent, meaning higher levels of economic activity. These factors could precipitate a period of US exceptionalism, especially if the US vaccine rollout continues to outpace other countries. The resulting curve steepening and higher yields are lending the US dollar some support, challenging the consensus negative view. Ultimately, however, underlying currency fundamentals are weak. The dollar’s primary currency reserve status continues to degrade, as evidenced by the decline in the dollar’s allocation to the International Monetary Fund’s Currency Composition of Official Foreign Exchange Reserves (COFER) data. At the same time, the US trade deficit hit a new record in November, while further fiscal stimulus is now likely to widen the US current account deficit.
Growth forecasts are increasing, led by the US, given expected fiscal stimulus
The relatively strong US growth backdrop has led to higher US yields, with the 10-year Treasury yield rising 19 basis points in 2021 so far to 1.1%. At the same time, the US dollar has broadly gained strength, with the trade-weighted dollar gaining 0.4% year-to-date. Having fallen by 12% in 2020 from its peak in March, this recent strength represents something of a reversal. However, the story is not universal. The US dollar has continued to underperform against more pro-cyclical currencies, having lost 1.4% against the Norwegian krona and 0.9% against the Australian dollar year-to-date. The dollar’s yield advantage over much of the G10 is also not a factor when it comes to emerging market currencies, where absolute yield levels remain attractive. All these factors make it difficult to generalise about the future dollar’s future direction. (All data as of 13 January 2020).
One potential near-term supporting factor for the dollar is that short positioning appears to be the consensus. Based on data from the Commodity Futures Trading Commission (CFTC) and our own positioning surveys, the evidence points to the market being both underweight the US dollar and overweight the euro. Our own indicator also suggests that long positioning in emerging market currencies is at levels not seen since early 2018. The positioning data presents the risk of a short-term reversal and should be noted.
What does this mean for fixed income investors?
Over the long term, weak currency fundamentals suggest that the US dollar’s recent decline is unlikely to be over. However, the quick change in the US cyclical outlook, as well as the slower vaccine rollout in Europe, diminishes the short-term case for the dollar to weaken further against low-yielding G10 currencies. When compared to more pro-cyclical currencies, including those in emerging markets, the dollar outlook is more nuanced. While investors should acknowledge the positioning risks, we believe that absolute yield levels, along with the expectation of a strong growth rebound, may continue to support emerging market currencies.
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.
Our common research language based on Fundamental, Quantitative Valuation and Technical analysis provides a framework for comparing research across fixed income sectors and allows for the global integration of investment ideas.
Fundamental factors include macroeconomic data (such as growth and inflation) as well as corporate health figures (such as default rates, earnings and leverage metrics)
Quantitative valuations is a measure of the extent to which a sector or security is rich or cheap (on both an absolute basis as well as versus history and relative to other sectors)
Technical factors are primarily supply and demand dynamics (issuance and flows), as well as investor positioning and momentum