Why it’s time to get off the U.S. dollar bandwagon

Everyone is betting on the U.S. dollar these days and no wonder.

Whether it’s Canadian equity investors buying domestic manufacturers with costs in loonies and sales in greenbacks, central banks dumping their euro holdings and heading across the Atlantic, or global investors seeking higher yields in U.S. treasuries, America remains the safe haven amid increased volatility in both equity and currency markets.

But seasoned investors know that one-sided trades like this can end up burning those riding the bandwagon. The U.S. dollar is particularly vulnerable if oil prices rebound, global economic growth exceeds expectations, or if the U.S. recovery stalls.

Much of the current optimism for the currency stems from the end of quantitative easing and anticipated rate hikes by the U.S. Federal Reserve, as U.S. economic growth prospects continue to lead the developed world.

Monetary easing by the Bank of Japan and European Central Bank has also served to pummel both the yen and euro, helping the U.S. dollar wrap up its best year since 1997 — appreciating almost 9% in trade-weighted terms.

But a gain of almost 20% by the dollar since mid-2014 also signifies a major tightening in financial conditions. David Rosenberg, chief economist and strategist at Gluskin Sheff + Associates Inc., equates the currency’s rise to a 200-basis-point Fed rate hike, punishing export-dependent sectors the most with a hit that is four times as large on corporate earnings than on GDP.

The negative aspects of the currency on U.S. companies are not widely appreciated yet, as it has a delayed impact. Nonetheless, it comes as little surprise that multinationals such as Apple Inc., Google Inc. and Procter & Gamble Co. all cited the stronger dollar as a hurdle in their recent earnings results.

Data released this week also showed that the U.S. trade deficit in December climbed to its highest level in more than two years, as lower exports and higher imports demonstrate how the greenback’s strength is making U.S. goods and services less competitive versus the global competition.

“As it is, the stronger U.S dollar has already started to punish U.S. companies with a strong export bias, and if we start to see a weakening of the jobs numbers in the coming days as a result of layoffs in the U.S. oil and gas sector, then that could quickly herald a sharp change in thinking, as well as a sharp drop in the U.S. dollar, as interest rate rise expectations get pushed out,” said Michael Hewson, chief market analyst at CMC Markets.

The run of recent U.S. economic data shows that the economy is not nearly as robust as the market thinks. For one thing, inflationary pressures remain benign and wage growth continues to be weak. At the same time, even though consumer confidence is at a multi-year high, that has yet to be reflected in retail sales and durable goods data, which are still lacklustre.

Disappointing Q4 GDP numbers further reinforce concerns about the U.S. economy, while Fed officials continue to discuss the prospect of monetary tightening. Talk of policy normalization is understandable, but perhaps policymakers should be a little more cautious given that the ECB prematurely tightened rates in 2011.

A whole host of central banks are cutting rates and shifting to more dovish stances, not to mention those engaging in QE, so there is a distinct possibility that growth in struggling economies will exceed expectations.

“Right now, we have this incredibly stimulative environment with very low oil prices, very low yields globally, and most central banks that are very accommodative,” said Camilla Sutton, chief FX strategist at Scotiabank.

She expects further gains for the U.S. dollar in 2015, but won’t rule out the possibility of a downward surprise if there is better-than-expected data out of places such as Europe, China or even Canada.

Expectations for Europe are very low, but the mood is reminiscent of the beginning of 2014. Almost everybody expected the euro to move lower last year, but it climbed above US$1.39 in May, as some data points were slightly stronger than expected and sentiment followed.

“None of it was strong, but it was just a little bit stronger than expected and I think that was one of the things that supported the euro well above what anyone had anticipated based on the fundamentals,” Ms. Sutton said.

For the Canadian dollar, whether or not you want to call it a “petro currency,” there is no doubt that oil prices are now the most important driver. The Bank of Canada has essentially tied its interest rate policy to oil prices for the near term.

But remember that oil prices can quickly rebound. Back in 1985-86, global growth was near 3% as it is now, the oil market was riddled with excess supply, and Saudi Arabia was unwilling to cut production.

Mr. Rosenberg noted that WTI crude fell from US$31.80 to US$10.40 between Nov. 21, 1985, and March 31, 1986. But months later, it had rebounded 42%. A year out, oil had surged more than 80%.

“The good news is that these sharp slumps in the oil price do not last for years — they last for months,” he said.

The loonie will hold its own against the greenback if oil prices stabilize, and that will also provide a breath of fresh air to other commodity currencies.

Another factor that will stop the U.S. dollar in its tracks is the eventual convergence of global bond yields. Negative yields in places such as Germany and Finland are becoming more common, making five-year U.S. treasuries at roughly 1.3% look pretty attractive. But it won’t last.

“Make no mistake: Bonds are already priced for the world to come to an end, and the world is not coming to an end,” Mr. Rosenberg said. “And looking at the massive net speculative dollar long positions on the InterContinental Exchange, the bull view on the greenback is arguably the most crowded trade there is across the planet.”