The dollar in the coming quarter

The first quarter of the year demonstrated once again that there is little more uncertain than a sure thing in the foreign exchange market. Rewind to mid-December, just before markets eased back for the holiday season, and the consensus firmly favoured a stronger US dollar in 2017. Of course, when sentiment is so strongly aligned, it means there are few marginal buyers left to enter the market. As a result, the consensus was confounded, as the DXY US dollar index fell -1.74% over the first quarter. Year-to-date the US dollar is down against every single major currency, and against all significant emerging market currencies with the exception of the Philippine peso and the embattled Turkish lira.

There were three proximal reasons the US dollar’s rally ran out of steam: (i) the evaporation of confidence in the Trumpflation trade, (ii) the stronger than expected upturn in European growth and inflation indicators, and (iii) the continued broad upturn in emerging markets.

The immediate post-election euphoria of US investors always looked likely to come down to earth. Initially, investors focused on the possibility of “Trump without the bad stuff”. That led them to price in stimulative fiscal measures, tax reforms that promised to be positive for both US corporate earnings and the US dollar, and more aggressive monetary tightening as the Federal Reserve leant against the resulting inflationary pressure.

The new administration’s apparent disarray during its first weeks in power, and in particular the Republican Party’s failure to push through health care reform in the face of opposition from its own members, emphasised just how challenging Donald Trump’s White House will find it to achieve its objectives. As investors reassessed the chances of early fiscal reform, and so of rapid Fed tightening, their expectations of US dollar strength weakened.

At the same time, investors were busy revising their outlook for European Central Bank policy in response to gathering economic momentum in the eurozone, rising headline inflation, and a change in tone that implied the ECB’s next move will be to begin to retreat from its ultraeasy monetary stance. Although that move remains a distant prospect, the narrowing of the real yield differential over the last month suggests the euro may have further to strengthen against the US dollar.

With the euro more than 57% of the DXY, this reassessment checked the US dollar’s rise, which in turn prompted investors to look more favourably on the continuing upturn in emerging markets. As a result, in March emerging market funds saw their strongest inflows since last summer.

In the light of these developments, it is perhaps surprising that the US dollar is not any weaker than it is today. The main reason is lingering political risk in Europe. Despite Dutch voters’ rejection last month of euroskeptic populism, fears remain that the nationalist Marine Le Pen could make a surprisingly strong showing in the first round of France’s presidential election in three weeks.

These fears have foundation. Although Le Pen trails frontrunning centrist Emmanuel Macron in the latest opinion polls, the large proportion of “don’t knows”—as high as 40% in some recent polls—means the possibility of a Brexit or Trump-style shock in the first round of voting cannot be ruled out with any confidence.

Such a surprise would be extremely bearish for the euro. So while the normalisation of investor expectations for the new US administration, the ongoing cyclical recovery in Europe, and the upturn in trade supporting emerging markets all suggest the US dollar will remain soft in the second quarter, the risk of a US dollar rebound against the euro cannot be ignored. The challenge for investors is to position for the chance that a strong showing by Le Pen in the first round of the French election—and she could quite conceivably win the most votes of any single candidate— triggers nasty short term volatility with a steep sell-off in the euro below US$1.05.

Exactly how portfolio investors should position themselves in asset markets ahead of the French election is the subject of a Gavekal Monthly, to be published this week. But obvious foreign exchange market hedges against the risk of a Le Pen shock include out-of-the-money puts on the euro against the US dollar. Equally, investors might like to consider a long position in the yen versus the euro, on the grounds that heightened political risk in Europe is likely to see Japanese institutions repatriate assets.

Alternatively, investors in search of an asymmetric hedge might prefer to establish a short position in French OATs. If Le Pen does well at the ballot box, French yields will jump. On the other hand, if she performs badly, the prospect that France’s economic upturn will continue under a more centrist, reform-minded president should support yields in the longer term, potentially providing a “heads I win, tails I don’t lose” pay-off.