The U.S. Dollar has paused in its rally higher. But is the end of the rally or just a pause? There are two factors to the recent USD strength; 1. Increase inflows into U.S. equites and Treasuries based ‘safe haven’ perspective and, 2. External factors from global trade tensions and emerging market weakness.

Last year the USD fell 10% against a broad base of currencies and we expected further weakness this year based on increasing U.S current account and fiscal deficits. The stronger USD goes against this but we believe it is global geopolitical factors that is keeping the dollar high.

Longer-term, HXL still believes the USD will fall based on U.S. twin deficits issue and the European Central Bank normalising monetary policy leading to a higher euro. As we have recently seen, leading U.S. activity indicators have dipped in the past month while U.S. import/export price data showed that the domestic economy is starting to feel the impact of President Trump’s tariffs. If it was not for external factors, this would have impacted on the dollar. In the short-term, as mentioned in our previous research note, we expect the EURUSD to overshoot 1.12 and may fall to 1.10 over the next three months.

Silver Lining

Financial turmoil in Turkey has dealt an unexpected blow to euro sentiment with the euro falling to its lowest level in more than a year against the dollar. While Turkey accounts for just 1.6% of Eurozone exports, the problems on the Eurozone’s doorstep appear to have rekindled worries over Europe’s long-term growth and earnings prospects. However, a weaker euro is good news for European companies operating globally as they become more competitive which may lead to higher corporate earnings and higher share prices on European equity indices.

 

Chart 1: Weaker Euro help’s European company earnings.

 

This is good news for European equities after the recent battering it has taken. Following our Research Note publish on August 18th, we still recommend buying European bank shares as the sell-off was an exaggerated reaction to Turkish exposure and because of attractive valuations and dividend payout expectations.

External Factors

Global trade tensions have benefited safe haven currencies including the yen and the U.S. dollar. Despite China extending an olive branch and accepting a U.S. invitation to discuss trade and economic ties in Washington later in August, we expect trade tensions between both countries to remain at least until after the U.S. midterm elections in November.

Following moves by rating agencies Moody’s and Standard & Poor’s to cut Turkey’s credit rating deeper into “junk” territory, Qatar’s central bank have signed a handout to Turkey to provide liquidity and support for financial stability. This this little to support the currency as the lira slipped again on news that the U.S may impose further sanctions. With credit downgrades completed and Turkey starting a week long holiday, we expect trade to be thin.

 

Chart 2: After three-days of gains, the lira weaken again on further possible sanctions.

In the absence any major shift in economic policy, double-digit inflation and the banking regulator putting a cap on lira swap agreements to deter short sellers, we believe it will not be enough to stop the slide in the lira. With the inability to hedge Turkish assets, this creates uncertainty as we witnessed in Malaysia last year and further downward pressure on the currency. As a consequence, foreign investors will likely sell both Turkish bonds and equities resulting in higher currency outflows.

Chart 3: Turkey’s attempt to stem lira losses may spell problems for its financial markets.

Since economic growth in much of the world remains strong, particularly in the U.S., the biggest risk of a downturn continues to originate from a combination of policy decisions from President Trump, the Federal Reserve and the Chinese leadership.

HXL Partners

CategoryForeign Exchange

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