Bracing for the return of the dollar within this year

 

Having lost almost 3 per cent so far this year, the greenback has been weighed down by the Fed’s indecision to increase interest rates, the rally of the yen amid the perceived failure of the Bank of Japan to spur inflation, and the resurgence of EM currencies as fund flows return to the region. 

But all that is about to change.

In my view, the dollar is about to change course again and regain strength in the remaining part of the year due to the following factors. 

First, the policy divergence: It is obvious that inflation in the US is on a different path from its peers in the eurozone and Japan. 

The US core inflation, the long trend in price levels excluding volatile items such as food and energy, has been running above 2 per cent since September last year, while in the eurozone and Japan core inflation is running well below a 2 per cent target, at 0.8 per cent and 0.3 per cent respectively. Thus the Fed is poised to raise the interest rate this year, while to ECB and the BoJ are looking to ease more. 

The difference in policy paths usually causes the dollar to appreciate.

Second, the positioning in the futures market: The net non-commercial long position in the dollar index futures market is quite low at the 29th percentile of the past year. 

This suggests that hedge funds and other speculative traders are holding a relatively low position in the US dollar, leaving room for more purchase down the road when the dollar is on a clear uptrend.

And third, the US money market fund reform: In order to reduce systemic risk stemming from the run on money market mutual funds, the US SEC is planning to apply new rules to “prime” money market funds, the funds that invest in riskier assets than T-bills, such as certificates of deposit or commercial papers. 

The new rules will require prime money market funds to float their net asset value and impose liquidity fees and redemption restrictions in case of financial crisis. As a response to more stringent rules, investors are shifting more than US$400 billion from prime funds to government funds (which do not abide by new rules) ahead of implementation date on October 14. Outflows from prime funds sapped liquidity in the short-term credit market and caused Libor to spike to the highest level since May 2009. A rising Libor will in turn drive up the dollar exchange rate.

The impact of a strong dollar is far-reaching. Emerging market bonds and equities, which enjoyed foreign fund inflows since the surprise Brexit vote in late June, could face renewed selling pressure as the dollar rises. 

The Chinese yuan, which has been quietly weakening against the dollar, could sink further and cause the market to worry about outflows from China. 

Commodities, such as oil and gold, will also come under the weight of a strong dollar. Japan equities, on the other hand, could offer a haven from a strong dollar as a weak yen will help support earnings due to the gains in foreign exchange conversions.

Komsorn Prakobphol is Head of Strategy at TISCO Economic Strategy Unit. He can be reached via |www.tiscowealth.com or |[email protected].