Making the case for U.S. dollar strength during the medium- to long-term is a hard task; until you look at the alternative. When looking at the lot the USD is pitted against, it is difficult to find something that could outperform the world’s reserve currency. Let’s take a look at the challengers.
EUR: Why won’t the euro outperform USD? How about Greece, QE, deflation, unemployment and contagion, just to name a few? While nothing is impossible, the likelihood for Europe to get all of its problems solved is negligible.
GBP: While the economic situation in the UK isn’t as bad as that in Europe, there is growing political uncertainty. The elections in early May could prove to be very divisive, with no clear majority expected to come out victorious.
CHF: The Swiss National Bank wants nothing to do with a currency that is getting stronger. Even though they dropped the floor in the EUR/CHF, they will go to great lengths to keep their currency weak.
AUD: The gradual slowdown in China has weighed heavily down under and even the Reserve Bank of Australia’s Governor Glenn Stevens says his currency is still overvalued.
NZD: See Australia in relation to China, but also Reserve Bank of New Zealand officials are talking about interest rate cuts instead of hikes; something that typically leads to a weakening currency.
JPY: Japan has risen substantially on this list thanks to some government officials who think the JPY is undervalued, but unless QE is tamed, the JPY likely won’t be a destination currency for investors.
CAD: A more optimistic tone from the Bank of Canada and rising oil prices heading in to the summer months has CAD bulls feeling frisky, but potential increased crude production from Iran could derail that good feeling.
All other currencies have issues and, even though the Fed may not increase interest rates until perhaps Q4 of 2015, they’re still talking about it. Everyone else is pointing in the opposite direction.
The dollar bull market is very young. The dollar breached its 2013 high in September and its 2010 high in December. Its power has been driven by a perfect storm affecting it and competing currencies. Quantitative easing has arguably delivered stability to the world’s largest economy, pushing it into pole position in terms of economic recovery. Meanwhile, most other global central banks are just beginning their QE journey.
Throughout the financial crisis, the inexact science of QE dogged the dollar. But as inflation remained at bay and recovery became apparent, its pre-eminence was solidified, based upon the prospect for yawning yield differentials with every other major currency. However, the abundance of positions backing a bullish dollar perspective has everyone married to the same stale view, and there can be few willing buyers left on the improving cost- of-carry argument.
So, if QE transformed the U.S. dollar, might it have the same effect, and quicker, on its competitors? QE was a big, bold and new experiment for the Fed. Many investors feared the policy would create rampant inflation and argued that excess money supply was being channeled to the equity market rather than to company and personal balance sheets. Even some members of the FOMC were skeptical. However, as the dust settled, the Fed’s stance has shifted into a desire to normalize policy. Hence, the dollar is not only benefitting from the prospect of higher yields, but also as the first currency to swim through uncharted waters of untested policies.
If that is true, surely the euro and the yen will find it easier to tread water faster than the dollar. It is, therefore, very possible that currency traders might embrace the upside of the Eurozone’s recovery faster than they embraced the American experience. As the April correction in the dollar leaves bulls checking their logic, upside pressure on the euro, yen and pound could pose a significant threat to the momentum behind the nascent dollar bull market.
Note: The views expressed by Andrew Wilkinson herein are the personal views of the author and do not reflect the views of Interactive Brokers Group or any of its affiliated companies.