The key driver behind a depreciating U.S. dollar

Richard explains what’s driving the U.S. dollar’s slide. Hint: yield differentials are taking a back seat for now.

The U.S. dollar index’s slide to three-year lows has caught many off guard, playing out despite interest rate differentials favoring the greenback. Different factors can dominate dollar swings—and higher U.S. yields are taking a back seat, for now, to rekindled risk appetite. We are neutral on the dollar’s near-term outlook.

Stronger global risk appetite

Foreign exchange movements can be tricky to predict due to their many drivers and the market’s ever-shifting focus. Gauging the direction of the world’s reserve currency is especially important given its influence on global trade activity and financial conditions.

We thought the widening U.S. yield advantage—the spread between two-year U.S. and eurozone yields last month hit its widest since the euro’s birth—would underpin the greenback in early 2018. Yet the dollar has kept sliding, and sizable positions have built up betting on a deeper drop. We find that stronger global risk appetite is playing a big role. Investors are ditching dollar safe havens to chase yield in emerging markets (EM) and returns in global equity markets. See the chart below. We see risk-on rebalancing eventually ending and yield spreads likely taking control again.
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Broadening confidence that the synchronized global expansion—now juiced with U.S. fiscal stimulus—can persist has spurred an embrace of risk assets globally. Our analysis of rolling 12-month periods shows cumulative inflows into non-U.S. funds over the last 12 months were the highest as a percentage of assets under management since June 2014. This portfolio rebalancing fits with our asset preferences based on our outlook for global growth, even if the fast pace of returns has surprised. Another surprise: U.S. equities have outperformed non-U.S. ones year to date, reflecting the risk-on backdrop, tax-related earnings upgrades and a weaker dollar.

icon-pointer.svg The Bid podcast: Jeffrey Rosenberg discusses the role fixed income can play in a market environment that’s heating up. 

Interest rate differentials typically are a good predictor of currency moves, but not this time. Our work shows a breakdown in the U.S. dollar’s historical performance relative to the role of U.S. yields against those of G10 economies. Yet if we look at the dollar’s performance relative to a broad mix of risk proxies, a positive relationship holds. The dollar-risk appetite link did wobble last week, with the dollar and equity markets both retreating. This shows how quickly these relationships can change. Other recent key U.S. dollar drivers include momentum chasing and a flattening U.S. yield curve not replicated in the eurozone and Japan. One factor unlikely to play a role is the repatriation of U.S. company funds held overseas. Reason: They mostly already sit in U.S. dollar assets.

What could reverse the downtrend?

The portfolio re-balancing trend will eventually lose steam. Yield spreads may also reassert control when markets reprice monetary policy expectations, which currently appear too dovish for the Federal Reserve and too hawkish for other central banks, in our view. We can’t predict the timing of a dollar reversal, but it may not be smooth given that short U.S. dollar positions are the most crowded since September 2017, according to BlackRock’s Risk and Quantitative Analysis Team. We don’t expect a sustained strong-dollar rally, as rates elsewhere will slowly approach those in the U.S. This is good news for the global economy. Read more market insights in our Weekly commentary.

Richard Turnill is BlackRock’s global chief investment strategist. He is a regular contributor to The Blog.

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