Bilal’s Macroscope: Do Not Fight Dollar Strength – Euro Could See Parity

It is so tempting to think the dollar rally is over. It has bounced 5% since mid-July. The Fed seems to be wavering on future hikes, and investors returning from summer vacation feel like they have missed the move. But here are five reasons why dollar strength will likely continue, which could see the euro head to 1.05, or even parity, and USD/JPY reach 150 or higher.

1.     Investors Are Not Bullish the Dollar

Currently, real money investors are heavily long euros, and hedge funds are slightly long after having been short at the start of the year (Chart 1). Importantly, looking at positioning, when the euro saw big rebounds, we find hedge funds were heavily short – notably at the end of 2016, April 2020 and late 2022. This time, hedge funds have yet to turn bearish on the euro and bullish on the dollar. This suggests the bullish dollar view is not a crowded trade – if anything, there are euro longs that could be unwound.

2.     US Growth Is Much Stronger Than Europe’s (and RoW)

Investors and economists consistently underestimate the resilience of the US economy. They have been calling for a US recession all year. However, not only has the recession not materialized, but growth expectations have been sharply revised higher (Charts 2 and 3). Meanwhile, Europe is seeing faltering growth. In the end, the US has better consumers, better energy and better fiscal policies than Europe – at least when it comes to being stimulative for growth. This is bullish US dollar.

3.     US Yield Story More Positive Than Euro or Japan

Simply put, short-term yields in the US are 5.4%, 3.7% in the Euro-area and -0.06% in Japan. The US has a clear carry advantage over the euro and yen. Moreover, the US is close to the highest yielder in G10, NZD, which has a yield of 5.5%. Being the highest yielder makes a difference for currency markets.

On top of that, the US has seen a much larger positive shift in future rate moves than either the Euro-area or Japan. The US 2y yield has jumped 22bps over the past three months, while the euro 2y yield has fallen 10bps and Japan’s has only risen 7bps. This fits our thesis that the market is underestimating the Fed’s terminal rate.

Taken together, this puts the USD in the best quadrant of high yielder and positive changes in rate expectations (Chart 4). Both the EUR and JPY are in worse quadrants.

4.     Terms of Trade Now Helping Dollar

Since 2020, the terms of trade of the US, Japan and Europe have diverged (Chart 5). The US has seen its terms of trade move in line with energy prices, while both the Euro-area and Japan’s have moved inversely to energy prices (Chart 6).

So the plunge in energy prices from late 2022 until recently saw the US terms of trade worsen, while that of the Euro-area and Japan improved. This helped the dollar weaken. We think energy prices are stabilizing with risks to the upside – thanks in part to supply cuts. At the very least, this suggests a drag on the dollar is no longer present. At best, it could provide a tailwind for dollar strength.

5.     Capital Flows Support Dollar Strength

Over the past 10 years, an important capital flow for the dollar has been US investor flows. Typically, US buying of foreign bonds has seen the dollar weaken and euro strengthen, while US selling has seen the euro weaken. Recent data shows US investors are reluctant to buy foreign bonds, which is supportive for the dollar (Chart 7).

Finally, major dollar downtrends typically coincide with deteriorations in the US narrow basic balance of payments (current account balance + FDI). There was a worsening between 2019 to 2021, but it has stabilized since (Chart 8). This is positive for the dollar.

Taken together, these factors suggest we could see meaningful dollar strength. Euro to parity and USD/JPY to 155 are not out of the question. Risk aversion could accelerate such a move. But even without, we could still see further dollar strength.

Bilal Hafeez is the CEO and Editor of Macro Hive. He spent over twenty years doing research at big banks – JPMorgan, Deutsche Bank, and Nomura, where he had various “Global Head” roles and did FX, rates and cross-markets research.

Photo Credit: depositphotos.com

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)