The curve of the US dollar by asset allocators is the climactic element of 2016.There are two synopsis that could develop.
Firstly, if excessive dollar gains were to choke the world’s largest economy, the growth differential between the US and the rest of the world would close. That is clearly an unwelcome scenario.
In the second synopsis, dollar strength does not become excessive and the US expansion is reinforced, giving space for global growth to stabilise or accelerate. In this way, the gap between growth rates closes not through US economic weakness but rather through a global pick-up.
The outlook is starkly different depending on which synopsis prevails. Risk assets struggle in the first synopsis. In the second synopsis risk assets accelerate, potentially leading to an eventual change in leadership from developed to emerging market assets.
We think the second synopsis will prevail — the more virtuous end to the US dollar cycle — but the interplay of interest rate differentials and dollar valuation early in 2016 will be critical in setting the market tone across all major asset classes over the course of the year.
The path of the dollar in 2015 roughly tracked the “will they or won’t they” evolution of expectations of Federal Reserve policy.
As we move through the early rounds of the Fed’s rate normalisation in 2016, we would expect some further support for the dollar.
How this plays out depends on the balance among valuation, terminal rate expectations, and the path of Fed tightening.
Only once the path and level of rates are accepted by the market can we expect that growth differentials between the US and the rest of the world, and the dollar’s overvaluation versus long run purchasing power parity (PPP) estimates, to drive the currency’s trajectory.
Recently, the sensitivity of the US dollar to yield differentials has increased markedly. This is perhaps unsurprising as the world finally starts to emerge from a prolonged era of zero interest rates, and policy divergence across major economic blocs reaches new highs.
In the early stages of the Fed’s policy normalisation we expect a repricing of the path of Fed hikes to provide support for the dollar. The market currently prices just two hikes each in 2016 and 2017; we believe that the strength of the US domestic economy warrants four per year.
Ultimately a terminal rate near 3.5 per cent rather than around 2 per cent, as is currently priced, will lend support to the dollar. But even allowing for this quicker pace of hikes, and higher terminal rate, the coming rate rise cycle will probably be shallower and longer than any in recent history.
Our expectation is for modest further upside to the US dollar in early 2016 as the start of the cycle creates a new high-water mark in global policy divergence.
The dollar is now overvalued on most of our metrics, however, and over the course of the year we anticipate that valuation headwinds, as well as a modestly better growth outlook in other regions, will limit further dollar appreciation.
We anticipate that risk appetite will recover further as the currency drag on US earnings eases, and as the upside risks to the dollar subside through the year, the outlook for emerging market assets has scope to brighten.
While stretched valuation can arrest the appreciation of the dollar, a reversal in the trend likely requires a closing of the growth differential to the rest of the world.
Since the global financial crisis, the world economy has been underpinned by the steady, if unexciting, expansion in the US.
As a result we weathered the eurozone crisis, the slump in commodity exporters, and, later, the slowdown in trade and manufacturing that centres on China’s economic rebalancing.
In some ways the US currency is now doing what it should — acting as a natural governor on growth and policy until growth differentials relax.
Simply put — the longer dollar strength persists, the more 2016 will look like 2015, but the sooner the dollar stabilises, the quicker we will see sentiment recover and emerging economies repair.