A disappointing opening half of the year left US yields looking less juicy to foreign buyers, taking the US dollar moderately weaker in the process. Sterling has been the only exception to that trend among the G10 currencies. Soft growth temporarily took the FOMC off the tightening warpath, pulling long rates down in the process. Without the attraction of rising yields, the US dollar tends to struggle given the net outflows associated with America’s trade and current account deficits. Central banks in other developed economies have tried to ease policy with a view to weakening their respective currencies against the dollar, but have found little success thus far in 2016. Indeed, Fed policy has dictated the majority of currency developments, with the exception of Brexit’s hit to the pound.
Looking ahead, improving US economic performance should buttress both Fed hike expectations and the US dollar over the balance of 2016. A hike we see before year end isn’t fully priced in, and the first hike is likely to cement expectations for more of the same in 2017.
With the market keying off of yield differentials, the greenback is likely to gain against just about every G10 currency in the coming four months. Expect that trend to reverse come 2017. A December rate hike from the Fed could see markets initially price in too aggressive a rate path for the ensuing year. With economic activity and inflation likely only able to justify two rate increases in 2017, the greenback will underperform against a variety of developed and emerging market currencies.
Monetary and/or fiscal stimulus in America’s trading partners should also be kicking in, reducing the pessimism on those markets. As we’ve seen this year, pauses in Fed tightening allows the weight of the US trade and current account deficit to take the dollar weaker against surplus counterparts like the Eurozone and Japan.
Overall, play the US dollar from the long side for now, but be careful not to overstay your welcome, as greenback gains should prove short lived.
Copyright © 2016 CIBC, eFXnews™
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