US dollar renaissance

The US dollar is enjoying something of a renaissance. Dollar fundamentals are on the mend and the currency is winning back investors’ hearts and minds. US growth is surging, job creation is in full swing and monetary policy is about to tighten. Interest rates and bond yields are set to rise. This week’s Federal Reserve meeting will be pivotal.

Other major currencies – the euro, yen and sterling – are fast falling out of favour with investors. Safe haven flows are flooding back into the dollar thanks to growing geo-political uncertainties. This could be the US currency’s defining moment.

The markets certainly stand in thrall and the dollar is showing a spirited recovery. It has notched up a straight 9-week winning streak – its best performance in 17 years. There should be more to come. The dollar seems set for long term secular recovery.

This week’s US monetary policy meeting will see crucial changes to Fed thinking. The Fed’s forward guidance for interest rate expectations and the Fed’s asset buyback programme are bound to come under scrutiny. Monetary policy is stuck in excessive overdrive.  The Fed’s key priority must be to stop over revving the economy.

Against mighty odds, the Fed has beaten off recession, defeated deflation and stopped the slide into financial meltdown. Animal spirits of recovery have been rekindled. US growth has surged to 4.2%, inflation is bang on the Fed’s 2% CPI target and the equity bull market is running at full kilter.

There are few signs of economic overheating yet, but policy needs to be normalised as soon as possible. US interest rates at zero per cent are hardly consistent with a healthy economy in the long run.

The Fed will turn hawkish this week. As a result, expectations for the first Fed rate tightening will be brought forward – probably sooner than next March. The Fed’s asset buying programme, which has quadrupled the Fed’s balance sheet in the last five years, will be closed within the next month.

This will have a seismic shift on interest rate expectations along the US curve. Short term interest rate futures should anticipate a faster tightening profile. As the Fed’s asset-buying fest dries up, the effects will be felt along the US Treasury curve in higher long term yields. This will be manna from heaven for US dollar currency bulls.

US dollar debasement has reached the end of the road. The Fed’s dogged commitment to zero interest rates and a seemingly inexhaustible appetite for Treasury debt has been the bane of the dollar in recent years. Artificially depressed US bond yields are now free to rise. The US Treasury market’s 33-year bull rally has come to an end.

Higher bond yields will be a powerful spur for US dollar longs. Ten year US government bonds already offer much better yield appeal relative to the Eurozone and Japan – and it looks set to get better as US yields continue to rise. Ten year US Treasury yields have hit a two-month high of 2.60%, 200-basis points over the Eurozone and 150-basis points over Japan.

On a relative basis the dollar looks a much better bet than many of its major currency rivals. The dollar stands head and shoulders above the euro, yen and pound.

The euro remains deeply affected by major uncertainties surrounding EMU – and whether the currency can even survive in the long run. The threat of recession, deflation and the impact of deep austerity cuts are forcing the European Central Bank into more super-stimulative monetary policy. Eurozone interest rates have dipped into negative territory and the ECB stands ready to bring out the Big Bazooka – quantitative easing. This is bad news for the euro. A slide back down towards parity against the US dollar is a very real possibility.

In Japan, the yen remains bowed by ‘Abenomics’, the government’s action plan to restore the economy to better health. As part of this, a weaker yen is aimed to boost exports and help meet the Bank of Japan’s 2% inflation target. The yen has already fallen 40% against the dollar in the last two years. A further 10%-15% yen slide could still be in the pipeline.

Investor perceptions towards sterling are being pummelled by the threat of Scottish independence and a possible future UK exit from the European Union. In the worst case scenario, an economically divided Britain, marginalised outside the EU, could lead to a very serious run on the pound.

Set against this backdrop, it is no surprise currency investors are turning to the dollar as a better safe haven hedge in uncertain times. With global political tensions heating up over the Middle East, Russian sanctions and the crisis in Ukraine, investors will increasingly turn to the dollar for sanctuary.

Emerging from six years of financial turmoil, US economic fortunes are in a much stronger position. This will not be lost on the Fed this week. And it will not be lost on the markets. The stronger dollar’s time has arrived.