What has driven the recent sharp rally in the US Dollar?

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29 May 2018

thomasdodds

The key theme in the foreign exchange markets since mid-April has been the sharp appreciation in the US Dollar against almost every other G10 and emerging market currency.

T
he Euro and Sterling have both declined to their lowest levels so far this year. The former has sold-off sharply to its weakest position since July 2017, while the Pound has now lost almost 8% of its value in a little over a month and is also trading at its lowest since November (Figure 1). Emerging market currencies have also suffered. The MSCI EM currency index, which represents a weighted-index of emerging market currencies against the USD, has shed over 10% of its value since late-January alone. But what has been behind the recent impressive run in the greenback?

Figure 1: EUR/USD & GBP/USD (May ’17 – May’18), Financial markets have finally begun to focus on the widening in interest rate differentials between that of the US and Europe. US government bond yields have been on a steady upward trend ever since the beginning of the year, as investors continue to price in a fairly aggressive pace of interest rate hikes from the Federal Reserve in 2018. The benchmark 10-year US Treasury yield increased above the psychological 3% level for the first time in seven years in late-April and, despite easing in the past few days, has now risen by 50 basis points since the turn of the year (Figure 2).

Importantly for investors, the spread between the US 10-year and equivalent bond yield in Germany has also widened to its highest since 1989 this month. This spread could increase further in the coming weeks should the trend of strong US data and below consensus Eurozone figures continue.

Figure 2: US/Germany 10-year Government Bond Yield Spread (May ‘17 – May ’18)
, Recent news out of the US economy has been solid. The US labour market is continuing to create jobs at a sufficient pace and headline inflation has risen to its highest level in over a year. The Fed’s preferred measure of inflation, the PCE index, is now above the Fed’s target level. By contrast, macroeconomic data out of the Euro-area has been soft this year, reinforcing the view that the currency bloc’s economy could be set to slow in 2018.

Overall Euro-area growth in 2017 was its highest in a decade, but recent data has failed to live up to such lofty heights. GDP growth slowed to 0.4% quarter-on-quarter in the first three months of the year. The recent business activity PMIs have also continued to fall short of expectations, with the composite index now at its lowest level since January 2017. Citi’s measure of economic surprise for the Euro-area, which tracks economic data relative to consensus forecasts of market economists, is currently at its lowest level in almost 7 years, while the same measure for the US has been in positive territory ever since September (Figure 3).

Figure 3: Citi’s Economic Surprise Index (2014 – 2018)
, Uncertainty over Italian politics has far from helped the Euro. The market had come around to the idea that the anti-establishment Five-Star Movement party (M5S) and The League would finally form a coalition government this month following the election in March. This, in itself, was not particularly well received, given a number of unorthodox proposals that may have threatened the country’s relations with the EU and worsened its already strained fiscal position. Italy is one of the most indebted countries in the world, with a debt-to-GDP ratio currently above 130% (Figure 4).

Figure 4: Italy Debt-to-GDP Ratio (2000 – 2018), The country was then plunged into a political crisis in late-May after the resignation of newly-appointed Prime Minister, Giuseppe Conte, effectively broke up the populist coalition. Conte’s resignation came after Italian President, Sergio Mattarella, had opposed the appointment of the Eurosceptic Paolo Savona as finance minister for fears of worsening the country’s future relations with the EU and provoking Italy’s exit from the Euro.

A new ‘technical’ government led by former IMF economist Carlo Cottarelli as interim Prime Minister has since been appointed by Mattarella. Cottarelli, known as ‘Mr Scissors’ for his cuts to public spending, has yet to present a programme, including a new budget. While he has been given a mandate to form a government, a lack of parliamentary support means that fresh elections in the autumn now seem likely.

Bank of England rate hike chances fade on soft UK data

Sterling has also a torrid run in the past month or so, with the currency bearing the brunt of a dimming likelihood that the Bank of England will raise interest rates in the UK this year. An easing in inflation, soft first quarter growth and a fairly dovish tilt taken by the BoE at its most recent meeting in May means that the market is now not pricing in a rate increase in the UK until November. Similarly to the Eurozone, the Citi Economic Surprise Index for the UK is also deep in negative territory, falling to its worst level since 2012 in May. A perceived lack of progress in Brexit negotiations has also weighed on the Pound.

What’s next for the US Dollar?

The latest bout of strength in the US Dollar has been broadly in line with our long standing expectations. With the Federal Reserve remaining on course to hike rates on a minimum of three occasions this year and most other major G10 central banks, notably the European Central Bank, a long way off following suit, we think that further gains for the USD seem likely in the coming months. This looks particularly the case versus the Euro considering the uncertain political situation in Italy.

US Treasury yields rise to multi-year highs

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US economy powers ahead, Eurozone falters

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Italy plunged into political crisis as populist coalition fails